Below are two rationales for the euro becoming more negatively correlated:
• Quantitative Easing (QE) to Buoy Equity Markets and Simultaneously Weaken Euro: In light of the new policy measures announced by the European Central Bank (ECB) in 2014—and the anticipation of new measures in 2015—many expect more policy action on the asset-purchase front, particularly with sovereign bond buying, corporate bond buying and outright QE. The anticipation of more ECB action is underpinned by declining growth expectations and mounting disinflation fears in the eurozone. This could lead to currency weakness and simultaneous risk-asset (equity) market outperformance, which can result in an even more negative correlation.
• Aggressive Policy Action to Encourage Currency-Hedging Activity: In 2014 the ECB launched aggressive monetary policy easing, including verbal intervention, negative deposit rates and other liquidity infusions (targeted longer-term refinancing operations, TLTRO). As a result, the ECB has succeeded in guiding markets toward a weaker euro in 2014. We have already started to see an increase in asset flows to currency-hedged strategies for Europe in 2014 and expect this to continue if asset flows pick up for European investments1.
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. To illustrate the point, Goldman Sachs recently downgraded its EURUSD2 forecast to 1.08 in 12 months, 1.00 (parity) by the end of 2016 and 0.90 by the end of 2017.
WisdomTree believes currency-hedged investment strategies are growing in prominence due to shifting policy winds among global central banks. While the ECB and the BOJ have newly embarked on aggressive easing measures, the U.S. Federal Reserve 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.
1Source: Bloomberg, as of 12/31/14.
2 EURUSD: Measures USD per unit of EUR, as of 1/9/14.
Important Risks Related to this Article
Investments in currency involve additional special risks, such as credit risk and interest rate fluctuations. 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.