The ECB’s second 3Y auction of funds takes place at the end of this month, with the first operation credited (by the ECB President) with staving off a credit crunch in the eurozone and, more tentatively, having contributed to the rally in risk assets seen so far this year. But does this mean that the euro will turn into the carry currency of choice?
At first sight, there may be something in this proposition. Since the first auction settled on 22nd December, the euro has weakened appreciably against all higher-yielding major currencies. Of course, it’s not as simple as that though, the single currency naturally having been beset by a number of negative forces, not least those surrounding Greece.
But there are three reasons why the euro is not likely to become the carry currency of choice in a continuation of stronger risk appetite. Firstly, there’s strong evidence that the primary reason for eurozone institutions taking cash is to cover upcoming refunding. The ECB’s own analysis in its latest monthly bulletin, conducted with the benefit of individual bank data, backed up this view by illustrating a strong correlation between the funding requirements of banks and their take-up of funds at the 3Y LTRO. Secondly, even though market rates have been pushed substantially lower (overnight funds averaging below 0.40% this year), the rate applied to the 3Y auctions is notably higher, being the average of the benchmark ECB rate over the lifetime of the loan, currently at 1%. Compared to the price of central bank funds for sterling, Swissie, dollars and yen, this remains 50bp higher than the next nearest. Finally, there’s relative strength and positioning. The yen and Swissie are both causing discomfort for their respective central banks and there are risks of intervention by both to weaken their currencies. For the dollar, whilst the prospect of further QE may have fallen off the agenda, the fact that the Fed is leaning in that direction is also serving to soften the greenback as risk assets rally. The final factor to bear in mind is the extent of the internal carry-trade - the re-investment of funds within the euro area. During the period when the ECB was offering 1Y funds to banks, data suggested that around half was ploughed back into the bond market. But this was at a time when yields were substantially lower, weighted average peripheral spreads over Germany of 1%, during 2009 and early 2010 vs. nearly 7.00% towards the end of last year. Data from the ECB (January Monthly Bulletin) suggests banks have turned into net buyers of bonds in November (by a mere EUR 1.4bln), but subsequent data are likely to show a substantial pick-up in the coming months.
All in all, unless the ECB cut rates substantially in coming months, there are strong reasons to believe that the euro is not going to become a fully fledged carry currency, with the internal carry trade being a far more dominant force than the cross-currency one.