Are Investors Seeking Protection from the Wrong Currency?

by Paul Amery

When it comes to currency ETFs, are many investors missing the biggest opportunity of all?

Currency ETFs have been in the news recently, largely in the US market and largely as a means of hedging against dollar depreciation.

Over the last two months, US investors have invested US$400 million in the currency ETF sector, which mainly consists of funds designed to benefit from the US currency’s fall. In the Currency Shares range, the Aussie dollar, euro, Canadian dollar, yen and Swiss franc funds have collected the most assets (in that order), which gives some indication of investors’ preferences.

But are investors focusing on the wrong currency when seeking to protect themselves? The US dollar’s problems are well known, but there may be another global currency in even greater peril – the euro.

Why the euro? Take a look at the two charts below, which I’ve reproduced from Willem Buiter’s Maverecon blog in the Financial Times (to read Buiter’s blog, click here).

The “narrow” and “broad” classifications refer to the number of trade-weighted currencies against which the euro’s level is measured: 12 and 41, respectively. The “real” versus “nominal” measures are those adjusted for inflation and those stated in headline terms (without adjusting for inflation differences between different currency regions). Buiter has used a “synthetic” exchange rate for the period before the euro came into existence.

Whichever way you look at it, the European single currency is trading at historic highs and it’s no wonder that a leading advisor to France’s President Sarkozy referred to the current exchange rate against the US dollar – around 1.50 – as “a disaster for the European economy and industry". Long gone are the days shortly after the euro’s introduction when currency traders referred to it as the “zero”.

In his blog, Buiter attacks the European central bank for inflexibility and for showing a preference for deflation rather than inflation. To be fair to the ECB, there’s not a huge amount that can be done from here on the rate-cutting front given that policy rates are already close to zero (1% for the main refinancing rate, 0.25% for the deposit facility for banks), although Buiter recommends a cut to negative territory for the latter.

Given that the year-on-year change in Eurozone inflation has registered as a negative figure for four months in a row, we’re already settling into deflationary territory. Add in an unemployment rate at a ten-year high and capacity utilization at a record low across the region (70%), and the case for a prolonged period of falling prices seems even stronger.

Although the ECB has so far toughed it out, there must be a serious question mark over how long recent currency strength can last. Perhaps US holders of euro currency ETFs and those invested in euro-denominated assets should start looking for an exit strategy, or at least a hedge.

Original post

Comments

[Mr. G:]

In my opinion, the current downtrend in the dollar is fundamentally based when compared to the Eurozone. The current price disparity between the two currencies seems to be guided by market sentiment globally. Considering the popularity of the spot market,trader psycology is confirming my observation.

The sentiment is never fixed in cement. Pay particular attention to thursdays US GDP report which is estimated at 3%. This may have a profound affect on the dollar index, particularly if the result comes in unexpectedly higher. On the weekly chart for the Euro, it is still in uptrend and all technical indicators on Barchart. com say sell the dollar(88%). The only question I have is how the Euro will respond on the spot market before the news is announced.GI

Oct 25 02:57 PM

[Mr. G:]

In my opinion, the current downtrend in the dollar is fundamentally based when compared to the Eurozone. The current price disparity between the two currencies seems to be guided by market sentiment globally. Considering the popularity of the spot market,trader psycology is confirming my observation.

The sentiment is never fixed in cement. Pay particular attention to thursdays US GDP report which is estimated at 3%. This may have a profound affect on the dollar index, particularly if the result comes in unexpectedly higher. On the weekly chart for the Euro, it is still in uptrend and all technical indicators on Barchart. com say sell the dollar(88%). The only question I have is how the Euro will respond on the spot market before the news is announced.GI

Oct 25 02:58 PM

[tripleblack:]

The EU has managed to paint themselves into a corner with the Euro. US monetary policy is the main thing propping up the Euro, but it is a very LARGE prop, given the ocean of money dumped into the zombie banks.

How long the EU can hold back the frantic calls from their poorer members regarding their imploding national economies is anyone's guess.

The French have this one right, it IS a disaster, and when the Euro turns, the fall could be ugly indeed.

I like the points posed by this article a lot. It appeals to my contrarian soul.

Oct 26 02:55 PM

[Crocodilian:]

The fault lies in Beijing. Freeze one part of a three body system, and you'll get what we've got: a dollar that falls sharply against the only other currency trading in volumes sufficient to absorb flows, the Euro. This is bad for the Europeans, not great for the US, and not a long term solution for the Chinese either (because as they redeploy into Euros, they're doing so at valuations that are clearly too high)

The world is stuck with Beijing's policy preference: they want massive exports in order to sop up excess labor supply at home, and will keep their currency too cheap in order to achieve this.

So if the dollar can't fall against its Yuan peg, it will fall against the only other currency where China might sock away export revenues.

Oct 26 07:33 PM