Euro emerging as haven in market rocked by yuan devaluation

New York

THE notion that the euro could be a haven in times of turmoil seemed preposterous just a few weeks ago. Yet that's exactly what it's become as the world gets rocked by everything from devaluations to bear markets in stocks.

The euro has surged more than 4 per cent against a basket of developed-nation peers in the past month, the biggest gain in the group. It's up against more of the world's major currencies than the dollar, yen, Swiss franc or pound. And it's climbing even as the European Central Bank expands the supply of euros.

While the rally signals confidence in the 19-nation currency union following the Greek crisis, it also complicates the ECB's efforts to jump-start the economy. That's because a stronger exchange rate has the potential to curb exports and slow inflation.

Said Thu Lan Nguyen, a strategist in Frankfurt at Commerzbank AG: "Safe-haven flows have been mainly targeted at the euro, which I think is stunning. The ECB won't just stand aside and may start to try to verbally weaken the currency. That's their prime instrument for delivering inflation."

China's shock devaluation this month sparked a rout in emerging markets that has prompted investors to unwind carry trades funded in euros. These deals involved borrowing at the ECB's near-zero interest rates to fund higher-yielding purchases, and cancelling them means buying euros back.

Growing scepticism that the Federal Reserve will raise interest rates in September is also supporting Europe's single currency at the expense of the dollar.

The ECB's quantitative-easing programme is even starting to support the euro by reassuring investors there's demand for European assets. The purchases started out debasing the currency by putting more money into circulation.

Said Neil Mellor, a senior foreign- exchange strategist at Bank of New York Mellon Corp in London: "As the euro's been funding China carry trades, a position wind-up has seen it soar. In the longer run, though, the strong-dollar view will prevail because of the divergent monetary policies."

The euro rose above US$1.17 on Monday for the first time since Jan 15, when Switzerland abandoned its euro-franc cap. It was at US$1.1559, down 0.5 per cent, on Tuesday morning in London.

It's up about 11 per cent from a 12-year low reached in March when the currency union seemed in danger of splintering and the ECB started its QE bond purchases. And it touched the strongest level this year in a basket of 10 rich-world peers tracked by Bloomberg Correlation-Weighted Indexes.

That wasn't in the playbook, either for ECB officials or most currency strategists.

Just three of 69 analysts predicted the euro would climb to its current levels by year-end when they were surveyed at the end of March. While ECB president Mario Draghi has consistently denied using QE to target the exchange rate, he's acknowledged the economic benefits a weaker euro can bring.

He has a lot of ground to make up. Eurozone inflation was just 0.2 per cent in July, against a target of close to 2 per cent, while the economy is forecast by analysts to grow 1.4 per cent this year, half the average pace across the Group-of-20 nations. BLOOMBERG