Active currency strategy beats the carry trade

The Euro has found a new role in the carry trade, as the interest rate differential with other G10 currencies widens and as its value slides, in particular against the USD.

The Euro carry trade is likely to continue so long as the Euro is besieged by crisis. Valentin Marinov, senior currency strategist at Citi, says: “The Euro should remain under pressure across the board as worsening euro zone recession darkens the outlook for the single currency in coming months. A potential resolution of the sovereign debt crisis is likely to provide only a temporary relief in our view. Diminishing cyclical support could push EURUSD to 1.20 or lower in 12 months.”

Effectively, the Eurozone economic problems are going to force the ECB to be still more accommodative, adding to the downward pressure on the Euro, and reinforcing its role as a carry trade currency. As Marinov says: “EUR has in effect become a carry funding currency after its rate advantage collapsed across the board.”

Until the global financial crisis in 2007-08, the most popular carry trade was the Yen. Since then, says Ugo Lancioni, managing director and portfolio manager of global fixed income and currency management at Neuberger Berman, “interest rate differentials within the G10 currencies compressed substantially,” causing the Yen carry trade to unwind.

Last December, the European Central Bank under the new leadership of Mario Draghi adopted an aggressive monetary expansion policy, described by one analyst as a ‘game changer’. Markets had expected an injection of €200bn but Draghi surprised the markets by launching a three-year LTRO (long-term refinancing operation) worth €500bn.

The move may have been bold, but the markets remain sceptical about the effectiveness of this facility, given the size and the nature of the debt problem facing the Eurozone. The expectation therefore is that the ECB may have to follow up with further measures to ease liquidity pressures. These include another three-year LTRO, an extension of the covered bond purchase programme and potentially unsterilized purchases of unsecured bank debt.

As expected, the Euro has steadily lost value against both USD and GBP. The Euro had been overvalued for some time, Lancioni says, so for the peripheral Eurozone economies, this easing has proved beneficial, though not so much for Germany. 

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