A species long absent from the currency markets is making a tentative return: the euro bull.
After Wednesday’s second round of cheap three-year loans from the European Central Bank, with eurozone banks taking €530bn this time, strategists were in upbeat mood.
The reason for this is simple. Financial markets have regarded the ECB’s longer-term refinancing operation, or LTRO, as a backdoor form of “quantitative easing” that has helped reduce the risk of a euro break-up or a sovereign default.
That banks tapped it again in substantial volumes was seen as a positive sign. A European credit crunch now looks more remote.
Wednesday’s dip on Federal Reserve chairman Ben Bernanke’s remarks aside, the question for investors is whether the single currency will respond to the confidence-boosting liquidity being pumped into Europe’s financial system with gains.
After tumbling during the autumn, the euro has already stabilised since the ECB’s first €489bn LTRO in December, rising 4 per cent against the dollar over the past 10 weeks. Though it barely reacted to the second LTRO figure on Wednesday, trading at about $1.34, the currency remains near three-month highs.
“What we’ve seen is that the diminishing risk factor has trumped the liquidity factor and the euro has strengthened,” says Alan Ruskin, head of foreign exchange strategy at Deutsche Bank. Currency analysts are ripping up their forecasts as a result.
UBS now predicts that the euro will be at $1.30 in a month, up from a previous prediction of $1.20. Analysts at Citi and HSBC think that it will hit $1.40 by the end of the year.
Many argue that the reduced likelihood of “tail risk”, or an extreme market-moving event, due to the ECB’s action is paving the way for wary investors to return to European assets and that this should be supportive for the euro. Progress by European leaders in tackling the Greek crisis has been important, too, in building confidence in the eurozone’s prospects.
Investors have been underweight in euro-denominated assets. Recent monthly surveys of global fund managers from Bank of America Merrill Lynch show that investors have not been net overweight in European equities since May 2011.
The survey for February shows that, while investors have stepped up purchases of European assets since the start of the year, they remain significantly underweight at 20 per cent, down from 31 per cent in January.
Jose Wynne, BarCap analyst, points to the narrowing in Italian bond yields after the latest LTRO as evidence that clients are regaining appetite for European assets.
Two-year Italian bond yields dropped to their lowest level since the end of 2010, reflecting in part the expectation that Italy’s banks would continue to use the cheap ECB loans to buy higher-yielding Italian sovereign debt.
Central banks, moreover, are trying to diversify piles of dollars accumulated in recent weeks after a rush by investors into emerging market assets and after the oil price rise.
Trading desks have reported increased interest from emerging market sovereign buyers in the euro as a result.
The single currency makes up a big part of central bank foreign exchange portfolios. By the third quarter of last year, global central banks held 26 per cent of their reserves in the single currency and just over 60 per cent in the dollar, according to the most recent data from the International Monetary Fund. Investment banks say central banks had slowed their purchases of the euro in the last few months of 2011.
The feeling that the ECB’s loans have reduced tail risk has also changed the way the single currency is traded. It has become less prone to sharp swings in other risky assets during so-called “risk on, risk off” trading. The oil price has become more volatile, with currencies such as the Norwegian krone and the Japanese yen, rather than the euro, among the bigger movers.
In fact, according to an index of “risk on, risk off” asset classes created by HSBC – with the S&P 500 the most risk on and triple A rated US Treasuries the most risk off – the euro has moved from a positive 0.75 correlation at the start of the year to less than 0.5 now.
That shift could have knock-on consequences for the euro. If the “risk on” influence continues to fade, investors may start to focus more on macroeconomic influences. That could be negative for the single currency. The economic outlook for the eurozone is hardly buoyant.
“The longer term issue is that you’re left with another central bank with a big balance sheet and a growth problem,” says Steven Englander, head of foreign exchange strategy at Citigroup.
Mansoor Mohi-uddin, UBS’s head of foreign exchange strategy, says European banks will start to take advantage of the fresh ECB money to fund overseas projects, converting euros to dollars and putting downward pressure on the single currency.
“By giving out all of this liquidity, I think the LTROs mask the fundamentals of the eurozone,” he says. “Eventually it will drain out again – but because it’s there for three years, it might take a while.”
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