(Bloomberg) -- Carry trade investors should raise a farewell glass to Mario Draghi.
While the European Central Bank President wasn’t dovish enough at Thursday’s meeting for rates traders, his setting the stage to lower interest rates deeper into negative territory in September means it will be even cheaper to borrow the euro and use it as a funding currency. Against its traditional rival the yen, the difference between three-month forward implied yields -- a gauge of borrowing costs -- stood at minus 23 basis points Wednesday, down from a high of plus 4 basis points in December.
With the Bank of Japan expected to stay on the easing sidelines for now -- it meets next week -- the spread is seen likely to widen even further.
“The euro is certainly a very compelling proposition now” from a funding perspective, said Vishnu Varathan, head of economics and strategy at Mizuho Bank Ltd. in Singapore. “It’s going to get better if you get a further pervasion of negative rates in Europe.”
Wall Street is taking notice. Morgan Stanley favored purchases of the Indian rupee, Russian ruble and Brazilian real funded in the euro, according to a note last week. Caesar Maasry, a New York-based emerging-market strategist at Goldman Sachs Group Inc., recommended buying the Mexican peso against the euro.
A strategy that sold euros and bought eight currencies in a Bloomberg emerging-market carry trade index has gained an average annualized 5.5% since the end of 2017, compared with a loss of 2.2% for a yen-funded strategy, according to data compiled by Bloomberg. While the euro- and yen-funded carry trades had almost the same returns from interest income, strength in the Japanese currency weighed on the latter’s performance.
The yen has climbed about 4% against the dollar since the end of 2017 amid signs the protracted trade war between the U.S. and China is hurting global growth. The euro has declined over 7% during the same period.
While economists forecast that the yen will advance more than 1% by year-end -- compared with the 3% expected for the euro -- traders could be wrong-footed during market turmoil. The Japanese currency has shown a much stronger correlation with equity volatility than the euro in recent years, suggesting heightened risk aversion could see a spike in the yen.
“I think people will feel safer with the euro,” Stuart Simmons, Brisbane-based senior portfolio manager at QIC Ltd., which manages the equivalent of $60 billion, said of a euro-funded carry trade. “The ECB is a little bit more activist at this point, and if people are wrong on the carry trades, the yen will punish them more than the euro will in a typical risk-off environment.”
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