• Aggressive Policy Action to Encourage Currency-Hedging Activity: Through verbal intervention, negative deposit rates and other liquidity infusions (targeted longer-term refinancing operations); the ECB could succeed in guiding markets toward a weaker euro. This could ultimately result in more currency-hedging activity from foreign investors, who are further encouraged by the miniscule cost of hedging at 0.1% annually.2 Citi argues that increased currency hedging can lead to EUR underperformance, even if foreign inflows continue into the asset markets in Europe. As I argued here, it appears that Draghi is determined to cap the euro’s upside potential, rendering the currency a source of unrewarded volatility.
• EUR the New Carry Currency: As Japan returns to an environment of inflation and higher growth, the Eurozone might be fighting an uphill battle of lower-for-longer growth and persistent disinflation. Additionally, the ECB might only be in its early innings of policy easing, and its actions have thus far supported risky assets through lower bond yields and higher asset prices. The euro, as Citi suggests, is becoming the new funding currency, which should serve to further support European stocks while weakening the currency.
The Case for Euro Hedging
Given that many of the themes discussed above are likely to play out over the course of the next few years, negative correlations in the Eurozone may very well persist and become even more negative.
WisdomTree believes currency-hedged investment strategies are growing in prominence due to shifting policy winds among global central banks. While the ECB has newly embarked on aggressive easing measures, the U.S. Federal Reserve is well on its way to ending QE late in 2014 and is largely expected to begin raising rates in the middle of 2015. This policy dichotomy could signal potential for a stronger dollar in the months ahead. From this standpoint, I believe we are in the very early stages of flows heading toward currency-hedged strategies—especially for Europe.
1Sources: WisdomTree, Bloomberg, as of 6/30/14.
2Source: Bloomberg, as of 5/31/14.
Important Risks Related to this Article
Investments focused in Japan are increasing the impact of events and developments associated with the region, which can adversely affect performance. Investments focused in Europe are increasing the impact of events and developments associated with the region, which can adversely affect performance. Foreign investing involves special risks, such as risk of loss from currency fluctuation or political or economic uncertainty. ALPS is not affiliated with Citi.