ECB out-doving the Fed boosts euro's allure as funder of carry trades

London

JACKSON Hole sharpened the contrast between a Federal Reserve telegraphing an end to stimulus and a dovish European Central Bank (ECB). For the euro, that means its status as a preferred funding currency just got a boost.

The discount on the overnight rate to borrow the common currency instead of US dollars rose earlier this month to the most since 2020. That juiced up returns on carry trades funded by the euro, which have been some of the best performers this year.

That trend got extra legs last Friday after Federal Reserve chairman Jerome Powell said it could be appropriate to start scaling back its US$120-billion-a-month bond-buying programme this year, though the central bank won't be in a hurry to begin raising rates thereafter.

That approach is miles ahead of the ECB, which said large-scale bond buying will continue next year, even after emergency asset purchases end.

"If the ECB was to persist in dovishness versus other central banks over the next few years, this would increase the attractiveness of the euro as a funder," said George Saravelos, global head of FX research at Deutsche Bank in London.

Against this backdrop, Brandywine Global Investment Management says it's using the common currency instead of the US dollar to finance purchases of emerging-market currencies. Nordea Investment Management sees it as a trend that's bound to gain traction.

Traders are able to finance positions in higher-yielding assets using the euro at a rate of minus 0.48 per cent overnight versus 0.09 per cent for equivalent dollar funding, often seen as the default option for investors in the developing world.

What's more, they can rest easy that their investments are less likely to get derailed by a sudden shift in outlook. ECB officials are still erring on the side of more stimulus even as they signalled last week that their latest shift in forward guidance doesn't necessarily mean a longer period of low interest rates.

"We're not using the dollar as a funding currency - it's really the euro and the yen," said Jack McIntyre, a Philadelphia-based money manager at Brandywine Global Investment Management, who has an underweight position in the common currency to finance purchases of emerging-market crosses.

Already this year, volatility-adjusted carry trades funded with euros delivered positive returns for 17 out of 23 emerging markets tracked by Bloomberg. The same measure for those funded by the greenback have delivered losses for 15 of them.

While a bulk of that performance can simply be explained by the euro's weakness - it has dropped about 5 per cent against the US dollar since the beginning of the year - it also underscores the impact of the widening policy divergence across the world's biggest central banks.

It's a rift that's poised to remain wide - according to market pricing - as Mr Powell cited the US economy's progress towards the Fed's inflation objective, even as he indicated a careful assessment of incoming risks related to the Covid-19 Delta variant.

Indeed, the discourse in financial markets is already beginning to shift away from when the Fed will start tapering its asset purchases, to how quickly they'll wrap up the operation.

"Since the Fed is sounding relatively more hawkish, it brings the relative margin of policy to the forefront," Brandywine's Mr McIntyre said.

He is betting that the global economy gets past the Delta variant relatively unscathed, that the US continues to experience robust growth into 2022 and that China adds stimulus to its economy.

That backdrop would lead to a payoff for riskier currencies such as the Chilean peso, the Mexican peso, the Brazilian real, the Malaysian ringgit and the rouble, he noted.

Traders are betting the Fed will hike interest rates 25 basis points by the beginning of 2023, while the ECB isn't expected to increase the deposit rate until 2024.

"Short term, this Fed-ECB divergence is quite disruptive as it contributes to tightening global monetary conditions via a stronger dollar," said Witold Bahrke, a senior macro strategist at Nordea Investment Management.

But over the medium term, the euro should continue to "gain attraction" as a funding currency, since the ECB will stick with its ultra-easy policy, he added. BLOOMBERG