ECB out-doving Fed boosts euro’s allure as carry trade funder

Jackson Hole sharpened the contrast between a Federal Reserve telegraphing an end to stimulus and a dovish European Central Bank. For the euro, that means its status as a preferred funding currency just got a boost

Jackson Hole sharpened the contrast between a Federal Reserve telegraphing an end to stimulus and a dovish European Central Bank. For the euro, that means its status as a preferred funding currency just got a boost. The discount on the overnight rate to borrow the common currency instead of dollars rose earlier this month to the most since 2020. That juiced up returns on carry trades funded by the euro, which have been some of the best performers this year. That trend got extra legs on Friday after Federal Reserve Chairman Jerome Powell said it could be appropriate to start scaling back its $120bn-a-month bond-buying program this year, though the central bank won’t be in a hurry to begin raising rates thereafter. That approach is miles ahead of the ECB, which said large-scale bond buying will continue next year, even after emergency asset purchases end. “If the ECB was to persist in dovishness versus other central banks over the next few years, this would increase the attractiveness of the euro as a funder,” said George Saravelos, global head of FX research at Deutsche Bank in London. Against this backdrop, Brandywine Global Investment Management says it’s using the common currency instead of the dollar to finance purchases of emerging-market currencies. Nordea Investment Management sees it as a trend that’s bound to gain traction. Traders are able to finance positions in higher-yielding assets using the euro at a rate of minus 0.48% overnight versus 0.09% for equivalent dollar funding, often seen as the default option for investors in the developing world. What’s more, they can rest easy that their investments are less likely to get derailed by a sudden shift in outlook. ECB officials are still erring on the side of more stimulus even as they signalled this week that their latest shift in forward guidance doesn’t necessarily mean a longer period of low interest rates. “We’re not using the dollar as a funding currency – it’s really the euro and the yen,” said Jack McIntyre, a Philadelphia-based money manager at Brandywine Global Investment Management, who has an underweight position in the common currency to finance purchases of emerging-market crosses. Already this year, volatility-adjusted carry trades funded with euros delivered positive returns for 17 out of 23 emerging markets tracked by Bloomberg. The same measure for those funded by the greenback have delivered losses for 15 of them. While a bulk of that performance can simply be explained by the euro’s weakness – it has dropped about 5% against the dollar since the beginning of the year – it also underscores the impact of the widening policy divergence across the world’s biggest central banks. It’s a rift that’s poised to remain wide – according to market pricing – as Powell cited the US economy’s progress toward the Fed’s inflation objective, even as he indicated a careful assessment of incoming risks related to the Covid-19 delta variant. Indeed, the discourse in financial markets is already beginning to shift away from when the Fed will start tapering its asset purchases, to how quickly they’ll wrap up the operation. “Since the Fed is sounding relatively more hawkish, it brings the relative margin of policy to the forefront,” Brandywine’s McIntyre said.