With the European Central Bank's key lending rate at a record low, the euro has emerged as a funding currency in so-called carry trades — a practice of selling weak, low-interest currencies to buy higher-yielding assets. A “combination of low, short-term borrowing costs relative to most other currencies and the diminished likelihood of an extended appreciation ... have enhanced the euro's attractiveness as a means of funding carry trades," said John Lonski, chief economist at Moody's Capital Markets Group. In a carry trade, investors sell or borrow against low-yielding currencies to fund investments in higher-yielding currencies, such as the Australian dollar. The euro is currently fitting the bill of a lower-yielding currency after the ECB earlier this month lowered its key lending rate to a record-low 0.75% from 1% to support the ailing euro-zone economy. Read more on the ECB rate decision. “The simple fact the euro received a shot in the arm from the ECB, ultimately expanding the monetary base, could make a case for the euro to become a favored currency in carry trades," said Robert Fuest, chief operating officer and head of investment research at Landor & Fuest Capital Managers. “This is obvious in the fact that it has ultimately become less expensive versus other major currencies." The U.S. dollar and Japanese yen had been instruments for carry trades with central bank interest rates in the U.S. and Japan near zero. The shift to the euro as a funding currency removes some downward pressure on the dollar and yen. That's not necessarily a good thing for the U.S. and Japan, whose exports benefit from cheaper currencies. Against the U.S. dollar, the euro EURUSD -0.26% recently sank to a two-year low and the euro EURJPY -0.26% has fallen to its lowest level since 2000 versus the yen. Currency exchange-traded funds have also reflected the move: quarter to date, the PowerShares DB U.S. Dollar Bullish Fund UUP -0.52% and the CurrencyShares Japanese Yen Trust ETF FXY +0.02% have each added more than 2%, while the CurrencyShares Euro Trust FXE +0.69% has lost around 4%. Get currencies data. The ECB move to push the overnight cost of capital closer to zero has apparently ignited a “wave of euro carry trades," said Richard Hastings, a macro strategist at Global Hunter Securities. That's why the euro-yen has “fallen apart." “When the ECB overnight rate was higher than the Bank of Japan's, there was an interest-rate differential that favored the euro especially against the U.S. dollar," he said. “That's part of the reason why we saw $1.35-$1.60 in the euro-dollar for a long time." But “when the ECB lowered the overnight rate recently, it ended the differential," he explained. “Since that time, the euro has declined against the yen consistently and somewhat against the U.S. dollar." The euro on Wednesday bought $1.2151, down 6% for the year. It bought 94.97 yen, off more than 4% for the year and 6% for the quarter. Read more on currencies. "The weakening euro — because of lower rates — leads to other trades, thus it turns the euro into a carry trade, and forces the euro much lower for as long as this process is built on a good foundation of bad euro fundamentals," Hastings said. “The fundamentals are there, so the trade persists." Marketwatch
