Strengthening of euro, yen could be irksome for ECB and BOJ

London

THE global financial turmoil has seen developing nations coping with weaker foreign exchange rates. This year's best-performing currencies may prove equally irksome for those central bankers.

The euro and yen are beating all their major counterparts because they're being treated as havens amid the downturn in commodity prices that's sent at least 16 currencies to record lows since the turn of the year. That won't sit well with the European Central Bank or the Bank of Japan, both of which would benefit from weaker currencies to help revive inflation and economic growth.

Worse still, signs are emerging that the currencies are poised to rally further. A narrowing gap between European and US interest rates, plus a growing gulf by the euro versus its effective exchange rate, indicate more gains are in the cards.

Hedge funds and large speculators are net bullish on the yen for the first time since 2012.

ECB president Mario Draghi may get a first opportunity to push back against the euro's strength after officials' monetary policy decision on Thursday.

"The ECB and the BOJ are not going to stand by and watch their currencies strengthen," said Lee Ferridge, the Boston- based head of macro strategy for North America at State Street Global Markets, a unit of State Street Corp. "If euro-dollar went back towards US$1.15, then you would see some comments coming at least from Draghi and maybe more talk of stimulus." State Street has about US$2.2 trillion under management.

The euro and yen have rallied as signs of an economic slowdown in China and a selloff in commodities roil global markets. The MSCI All-Country World Index declined into a bear market and crude oil prices fell to a 12-year low, while Russia's rouble and Mexico's peso tumbled to record lows on Wednesday.

That's raising concern that the outlook for global economic growth is weakening and the US Federal Reserve will have to reduce the amount of policy tightening it expects to deliver this year.

Both the euro area and Japan have current account surpluses, making them attractive venues for capital in times of risk-off sentiment. The common currency has advanced 0.3 per cent against the US dollar this year, while the yen has added 2.8 per cent.

This may force the ECB's hand when it meets on Thursday. The euro already stands to get a boost versus the dollar from the shrinking gap between yields on German and US sovereign debt, according to State Street's Mr Ferridge.

Other indicators reveal that the common currency's effective exchange rate has diverged from the euro's rate versus the dollar. Options prices show traders are near the most bullish on the common currency against the greenback since 2013.

"We are at a level in the effective exchange rate where the ECB intervened verbally in the past," said Valentin Marinov, head of Group-of-10 foreign exchange research at Credit Agricole SA's corporate and investment banking unit in London.

Officials in Japan face a similar issue. BOJ governor Haruhiko Kuroda said last week that officials won't hesitate to add stimulus if necessary. The central bank next meets on Jan 29.

"Current financial market conditions are doing real damage to the BOJ's attempts to lift underlying inflation pressures," Derek Halpenny, the London-based head of European markets research at Bank of Tokyo-Mitsubishi UFJ Ltd, wrote in a note. "Speculation of additional monetary easing is likely to intensify, but it is difficult to envisage action under current circumstances that would have any meaningful impact on reversing equity market declines and yen strength."

Hedge funds and other large speculators were net long the yen for the first time in three years in the week through Jan 5, and extended those positions last week, Commodity Futures Trading Commission data show.

Money managers are sticking with bets that policymakers will steer the euro lower. After Mr Draghi triggered a euro rally in December with a smaller package of stimulus measures than was forecast, they are relying on him to make amends at Thursday's policy meeting by indicating more easing to come.

"Markets are split between general risk aversion, and euro being a safe haven, given the source of the shock is China and emerging markets, and prospect of further ECB easing," said Salman Ahmed, chief strategist at Lombard Odier Investment Managers in London. "Euro dynamics will depend on the size and nature of any ECB easing vis-a-vis the Fed." BLOOMBERG