The European Central Bank may finally have dealt a blow to the euro's resilience during the regional debt crisis.
Last Thursday's decision to cut the deposit rate, the rate commercial banks earn for parking money with the central bank, from 0.25 percent to zero puts the single currency in a no-win situation.
It makes the euro less attractive when riskier or higher-yielding assets, such as stocks or currencies of strong economies, are performing well.
Currencies such as the safe-haven US dollar and the yen, which fall when stocks rise, usually perform better during period of financial market stress. But with the euro zone's worsening debt crisis at the centre of market angst, investors are less likely to buy the euro at times of uncertainty.
This means a double hit for the euro, which lost more ground against the dollar since the interest rate cut than it did in the whole of the first half of the year.
“We think the cut in the deposit rate to zero is very significant for foreign exchange markets. This implicitly signals a greater ECB easing bias and a desire for a lower euro,” said George Saravelos at Deutsche Bank in London.
Such low rates are likely to encourage investors to sell euros and use the proceeds to buy higher-yielding assets, possibly displacing the Japanese yen and the US dollar as the traditional “funding currency” of choice.
These trends will ensure the euro extends a slide which has already taken it to two-year lows against the dollar, decade-lows against a trade-weighted basket of currencies , and record lows against the Australian dollar.
Saravelos expects the euro to be trading at $1.20 in the coming months, compared with the two-year low of $1.2225 set on Monday.
This fall may help the euro zone's floundering economy get back on its feet by making exporters' products more competitive in overseas markets and by increasing the euro-denominated value of their foreign currency earnings.
A new role as a funding currency would mark a sea change in the way the euro trades.
“We could be moving into a new paradigm where you see a mildly risk-positive environment but the euro under pressure,” said Chris Turner, head of currency strategy at ING.
This would cause the euro to fall when equities rise and could leave it particularly vulnerable against higher-yielding and growth-linked currencies, which tend to move in lock step with stock markets.
Some of the euro's biggest falls in recent days have come against currencies such the Australian and New Zealand dollars and the Swedish crown, whose economies are in better shape than that of the euro zone and which are backed by higher rates.
Sweden's main interest rate is twice the ECB's refinancing rate. Australian rates are even higher at 3.5 percent.
“By cutting the deposit rate, the ECB has made the euro the funding currency of choice,” said Ned Rumpeltin, G10 currency strategist at Standard Chartered.
“The nearly 800 billion euros on deposit with the ECB are now a cost to the banks and will slowly be put to work elsewhere.”
CENTRAL BANK DEMAND
The ECB's zero deposit rate will compound Asian central banks and sovereign wealth funds' inclination to trim their holdings of euros in favour of currencies issued by countries in solid fiscal health, and ideally with a triple-A credit rating.
“Now the ECB has made the euro less attractive there is all the more reason for diversification trades to be considered again or enhanced,” said Jane Foley, senior currency strategist at Rabobank.
Over the past decade, central banks in Asia, the Middle East and Russia sought to diversify large holdings of US dollars, mostly into euros. But now Europe's debt crisis is leading many to switch their euros into better alternatives.
International Monetary Fund data shows “other currencies”, including commodity-linked, Scandinavian and emerging currencies accounted for more than 5 percent of reported reserves in the first quarter from 2.1 percent at the beginning of 2009.
It also showed the proportion of euros in their reserves declined in the first quarter compared with the previous one.
Traders say diversification out of euros into these “other currencies” has picked up since the period covered by IMF data.
A London-based head of FX sales at a major bank said some central banks or reserve managers had been switching small portions of their reserves into Australian dollars and that other such institutions were considering such a move.
This trend will be underpinned by the Swiss National Bank's policy of buying euros to stop it falling below 1.20 Swiss francs. Some of the euro the Swiss central bank buys are then used to buy Australian dollars and Swedish crowns.
For investors, the question now is how far can the euro slide against higher-yielding currencies such as the Australian dollar and the Swedish crown.
“My general bias is to expect those currencies to outperform the euro. But some of them have moved quite sharply ...(so) maybe we need to see a bounce (in the euro) or a period of consolidation first,” said Steve Barrow, head of G10 currency research at Standard Bank. - Reuters