By Anirban Nag
LONDON (Reuters) – Anyone betting against the euro may well find this strategy remains a “pain trade”, even though the common currency has fallen to a 10-week low against the dollar this week.
This drop looks unlikely to be the long-awaited breakout in what has been one of the world’s most stable free exchange rates and, in a remarkable change of fortunes, the euro zone is showing signs of becoming a safe haven.
Analysts have been forecasting a weaker euro for at least three years but, despite economic crisis within the euro zone and even doubts the currency would survive, it has defied expectations and traded in a relatively narrow range.
Since the end of 2011, the euro has held between $1.20 and $1.40, supported by a widening euro zone current account surplus and the European Central Bank’s tactics which have differed sharply from those of its peers.
While both the U.S. Federal Reserve and Bank of Japan have flooded their markets with cash by buying bonds at a record pace, the ECB has acted much more cautiously, reabsorbing much of the money it has injected into the banking system.
In accountants’ terms, the ECB has shrunk its balance sheet while the Fed and BOJ are expanding theirs.
The robust euro has created its own problems. A strong euro lowers the cost of imported goods, complicating the ECB’s fight to avoid damaging deflation in the euro zone. Consumer prices rose just 0.7 percent year-on-year in January, less than expected and well below the ECB’s target of close to 2 percent.
Talk that the ECB might loosen policy in response as soon as this week pushed the euro to $1.34765 on Monday. It also hit a two-month low against the yen and a six-week trough versus the Swiss franc.
But this weakness has been offset by inflows as investors pull money from falling emerging markets. Far from being threatened, the euro is seen as something of a haven.
“Trading the euro, especially euro/dollar will remain a pain trade,” said Geoffrey Yu, currency strategist at UBS. “Unless the ECB cuts the refinancing rate and decides to expand its balance sheet, the euro is unlikely to fall much.”
Trends in the options market indicate that while investors are betting on euro weakness before the ECB meeting on Thursday, overall there is hardly a rush to buy protection to hedge against a sharp drop in the common currency, especially in six to 12 months’ time.
A Reuters poll released on Monday showed traders expect the ECB to keep monetary policy unchanged on Thursday. If that happens, the euro will recover lost ground.
Another reason investors are not rushing to place big bets against the euro is that signs economic growth in the euro zone is picking up could make the ECB hesitate in easing policy.
Further, euro zone banks are still repaying crisis loans to the ECB, cutting excess cash in the banking system, and pushing up short-term money market rates. Higher short term rates make the euro more attractive for investors seeking higher returns.
And lastly, euro zone banks – which according to the Bank for International Settlements have over $3 trillion exposure to emerging markets – seem to have started the process of withdrawing money from those falling markets. That is likely to underpin the euro.
Jane Foley, a currency strategist at Rabobank said these inflows are allowing the euro zone to maintain a record current account surplus. This stood at 23.5 billion euros in November, up from 22.2 billion in October.
“The strength of this surplus is acting as a comfort blanket for the euro. Even though the currency was deeply embroiled in a crisis not very long ago, the euro is exhibiting some safe-haven behavior,” she added.
In mid-2013, when emerging markets (EM) began to wilt after the Fed signaled it was ready to reduce its bond buying, investors rushed to the euro as the second-most liquid currency after the dollar.
Foreign investors bought 250 billion euros of euro zone stocks last year and pumped 100 billion euros into euro-denominated money market funds, official data showed. In January, funds began to flow out of emerging markets.
“Its recent correction lower notwithstanding, investors may be hesitant to sell the euro further given its status of a safe-haven currency,” said Valentin Marinov, currency analyst at Citi.
This may also apply versus the “G10 smalls” – less liquid currencies in the developed world such as the Australian dollar. “The euro could remain supported against G10 smalls and EM currencies if recent market volatility escalates some more,” said Marinov.
However, the euro could drop sharply if the ECB takes dramatic steps such as stopping soaking up all the money it pumps into the banking system via regular money market operations, or cutting the rate at which banks park excess funds with it to negative.
Until that happens, excess liquidity in the euro zone banking sector will remain close to its lowest levels since late 2011. And with that there is a risk that short-term money market rates could rise.
Undoubtedly, short-term interbank rates have slipped since late last week, but they remain relatively high and volatile, putting pressure on the ECB to step in and pump cash.
“Short-dated rates have a good relationship with the euro,” added UBS’s Yu. “The ECB has to address the money market problems if the euro is to weaken.”
(editing by David Stamp)