Cumulative FX flows into Europe have softened in recent weeks, but remain solidly positive at around net 5% on a four-week and 12-week basis, according to Crédit Agricole data.
However, since the European Central Bank (ECB) in September cut its main short-term interest-rate target to 0.05% and the interest rate it pays on excess bank liquidity to -0.2%, few investors are willing to take on the currency risk.
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“Since [ECB president Mario] Draghi went negative we have seen a change of attitude from Middle Eastern and Asian sovereign wealth fund and central bank constituency, and now people don’t want to be exposed to any currency fall,” says Adam Myers, European head of FX strategy at Crédit Agricole. “Unhedged purchases of euros have almost completely dried up.”
Asian and Middle Eastern investors have been active buyers of euro-denominated assets in recent years, amid printing of dollars by the US Federal Reserve that has increased demand for diversification plays. Those purchases until recently were almost entirely unhedged, as the euro traded in tight range against its US counterpart.
One indicator of diminishing demand for euros is the eurodollar basis swap, which has widened out to minus 13 basis points in recent sessions, from close to flat over the summer. A widening of basis swap spreads is an expression of the dollar scarcity effect, and represents in real terms a migration of European money out of Europe and into the US.
“Following the introduction of negative deposit rates in Europe, banks have moved money abroad, and some of that has involved depositing at the Fed or purchasing dollars outright,” says Valentin Marinov, head of European G10 FX strategy at Citi. “That demand has been reflected in the swap market.”
Simple rationale
The rationale behind the migration of European bank funds into US deposits is simple: the avoidance of a deposit rate penalty of around 20bp on short-term deposits, which more than covers the 13bp swap price and 5bp deposit insurance fee charged by the Fed.
“Even with the deposit insurance fee, you are still better off as a European bank parking your money with the Fed, and right now we are seeing a sustained demand for dollars,” says Marinov.
An interesting corollary of the widening basis swap spread and jump in dollar demand is that it has had little impact on demand for European assets, bankers say. Despite a recent sell-off, and mixed data out of Europe’s largest economy, Germany’s DAX stock index remains near a record high, while funds tracking the iBoxx € Liquid High Yield 30 Ex-Financial index have given up only a small proportion of the gains seen in 2012 and 2013.
One recent trend, however, is a move by large Asian and Middle Eastern investors out of European government debt – the German 10-year bund yields around 0.93% – and into corporate securities, bankers say.
Part of the reason for accelerating demand is a surge in issuance of corporate bonds, which has seen sales in euros rise 18% year-on-year to around €878 billion. Issuance in US dollars, meanwhile, has declined 3% to $2 trillion.
| What is very interesting in Europe is the parallel in Japan, where asset markets rallied after the bank moved to QE Adam Myers |
Part of the reason has been a medium-term decline in the eurodollar asset swap rate, from the 70bp to 80bp seen in 2013, which makes it cheaper for US companies to fund in euros and less attractive for European issues to go abroad.
Some 15 Asian corporates (ex-Japan) have issued euro-denominated bonds since the beginning of 2013 in deals worth €6.4 billion, according to data provider Dealogic. An example was Bharti Airtel, India’s largest mobile-phone carrier, which in May offered euro-denominated securities for the third time in six months.
However, now that the basis swap rate is starting to creep up again, there is a question over whether issuers, including Coca Cola and Australia’s Origin Energy, will continue to see euro-denominated liabilities as an optimal strategy.
With future levels of non-European supply in question, and the central bank continuing to expand its balance sheet, it may be that European assets continue to perform, even as the euro declines.
“What is very interesting in Europe is the parallel in Japan, where asset markets rallied after the bank moved to quantitative easing,” says Crédit Agricole’s Myers. “We could see the same impact in Europe, with technical demand remaining strong, but that not being enough to protect the euro.”