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Euro's Surge Shows Power of Carry Trades Unwinding

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02/28/2020 | 06:03am EDT

By Paul J. Davies and Anna Isaac

The euro has rallied against the dollar this week, contrary to what might be expected in a weak economy that has the biggest outbreak of coronavirus outside of Asia.

Investors have piled into the common currency, driving it 1.8% higher against the dollar since the end of last week. But they haven't been buying the euro because they think the eurozone is on course for a turnaround, or because Europe has suddenly become a haven for funds when global risks escalate.

In fact, the reason for these counterintuitive market moves, according to some analysts and investors, is the carry trade: Investors who were borrowing cheap euros to invest in riskier assets are now, amid the recent market turmoil, selling those assets to buy back euros and unwind their trades.

"Markets are not always rational," said Jordan Rochester, a foreign-exchange strategist at Nomura Holdings. "We have a situation developing in Italy right now with cases getting higher, but the euro moving upwards. This is a washout of positions of carry trades."

Some analysts and investors have been puzzled this year by the euro's persistent weakness when many of the traditional drivers of the currency have been improving. The difference between interest rates in the eurozone and the U.S. has shrunk, which in theory should make the dollar less attractive. At the same time, the eurozone has enjoyed growing capital inflows despite its growth problems.

Since its recent low on Feb. 20, the euro has risen 2.4% against the dollar to $1.104. It has jumped 5.9% against the rand and 7.8% against the peso over the same period.

This is similar behavior to currencies more traditionally seen as so-called havens, which investors buy when the world looks riskier, such as the Swiss franc and Japanese yen. The franc is up 2% against the dollar since Feb. 20 and the yen is 3.1% higher.

The previous weakness and surprising strength now is in part likely due to hedge funds selling euros and buying higher-yielding currencies such as the peso and rand, then reversing those trades this week. Leveraged investors had been increasing their bets against the euro in February, according to weekly net exposure data in futures markets from the Commodity Futures Trading Commission, which is one indication that they were pursuing such carry trades.

However, other forms of borrowing in euros by non-European investors -- through banks or bond markets -- have also surged in the past few years, according to analysts, which is having a similar effect on the euro.

However, another important dynamic at play is the end of the month, when some investors look to balance their books and some banks call in short-term loans. A lot of this week's euro rally could be investors closing out bets against the currency, according to Kit Juckes, a currency strategist at Société Générale.

"The market was clearly short euros and there is very likely to be buying related to short covering at month-end," Mr. Juckes said.

Either way, the euro is likely to weaken against the dollar again next week, according to analysts. Nomura's Mr. Rochester said the risks to the eurozone are still higher than the risks to the U.S.

"The euro is a safe haven versus emerging markets, as it has been a carry-trade funder for some time," Mr. Rochester said. "But it's not clear to us that this will cause a medium-term move higher in the euro versus the dollar."

Write to Paul J. Davies at paul.davies@wsj.com and Anna Isaac at anna.isaac@wsj.com

 

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