Why Euro Pop Up ?

Global financial markets are witnessing classical risk-off sentiments as emerging markets are witnessing broad sell-off in their currencies, which was ignited by Yuan devaluation (Read More). China has devalued Yuan after an alarming decline in its exports, sending ripples to financial markets. Major equity markets witnessed heavy sell off lead by Chinese equity markets(Read More), which fell more 25% since Yuan devaluation.

Historically, the US dollar tends to appreciate against the major currency pairs during such turbulent times. Interestingly, US dollar has failed to live up-to this notion during current crisis. Though, the US dollar has raised sharply against emerging market currencies, but it fell nearly 4% against the major currencies. On the other hand, Gold, Japanese Yen, Swiss Franc and US treasuries surged on safe haven demand. So why US dollar failed to live up-to the expectations? It is because recent volatility and pace of market decline, which do raise major concerns of weak global growth, has definitely created a doubt in US FED member regarding interest rate hike.

Though the movement in the US dollar is unusual, but current piece caters to sharp gains in Euro, especially against emerging market currencies. Ever-since Yuan devaluation Euro has surged nearly 7% against the US dollar and more than 11% against Indian rupee. The recovery in Euro is so strong that it gives a false sense of reversal story in EUR/USD pair, which is still in bearish trend. 

	Before Crisis	24th Aug	Change
US dollar index	97.91	92.62	-5.4%
EUR/USD	1.09	1.17	7.3%
GBP/USD	1.5597	1.5818	1.4%
USD/JPY	125.27	115.89	-7.5%
USD/CHF	0.9751	0.9255	-5.1%
Gold	1090	1159	6.3%
EUR/INR	69.76	77.66	11.3%

Short Background

The Euro has been in a primary downtrend from last one year as it has lost nearly 20% against the US dollar during this period. This fall EUR/USD pair is strongly supported by diverging monetary policy stance between the two major economies. On one hand, the US FED is on the path of raising interest rates, first times after six years. On the other hand, the ECB has kept interest near zero levels and been on a bond buying spree to fuel the growth in the European economy, which has been struggling with weak demand and low inflation.

Case in Point

As ECB pledged to keep interest rate near zero levels, Euro became prime borrowing currency. The market participants started to enjoy positive carry trade by borrowing money in Euro terms and started to invest in high interest paying emerging markets and risky equity investments. At same time, investor remained reckless by keeping currency risk unhedged on expectation of further decline in Euro. Soon after Yuan devaluation, when emerging market currencies started to witness sharp depreciation this carry trade turned negative (Owing the losses on EUR/EMCs pairs). The market participants, who have borrowed in Euro terms, were forced to hedge the currency creating huge but temporary demand for Euros. Hence, the current rally in EUR/USD pair has been majorly due to carry trade unwinding and risk aversion.

Are current levels of EUR/USD pair sustainable?

First, let us understand why major central banks, including ECB, are running ultra-eased monetary policy? The prime target of running ultra-eased monetary policy is to revive domestic economic growth and inflation and secondary favorable outcome is weak currency. A weak currency leads to recovery in exports revenue, which in turn revive the domestic economic activity. The current gains Euro will put further pressure on European economy, which is already surviving on borrowed oxygen. Secondly, the recent economic numbers from US and Europe clearly paints striking difference in economic recovery. US second quarter GDP grew by healthy 3.2%, while German GDP still struggling at 0.4% growth rate.

Finally, the current Chinese crisis has enough fire power to push US rate hike (Read More) on back burner, but the current diverging monetary policy stance will remain intact. Hence in all likely hood, the EUR/USD pair will soon start its southward journey toward 1.10 levels before aiming for target of parity. 

Source : Bloomberg

Chinese Mayhem

On 2^nd bi-monthly monetary policy, RBI governor Mr. Raghuram Rajan has reiterated his stance on currency – The RBI will continue to monitor currency markets to keep the rupee volatility in check. Back then, a currency analyst might have thought that how much more calm markets does he want? The Indian rupee had been trading in a broad range of 63.30 to 64.30 from last four month. Indian rupee had showed remarkable strength among its peers as major emerging currency markets witnessed sharp depreciation. The key reason for the same was substantially improved macro-economic indicators, mainly improved current account deficit and sustained decline in headline inflation and strong FII and FDI flows Then this dream run of Indian rupee ran-into Chinese Mayhem and rest is history.

Short Background:

Since 2005, China has been following a closely managed foreign exchange regime, where in it sets central parity foreign exchange rate every session and the rate is not allowed to move more than 2% either side. The China being a net exporting country could afford the gradual appreciation of Chinese Yuan against the US dollar. With USD/CNY pair falling from levels of 8.27 in July 2005 to 6.06 in July 2014. 

Case in Point:

After July 2014, global markets witnessed key developments which forced Chinese authorities to devalue Yuan. The commodity markets literally collapsed with major commodities falling nearly 50% due to supply glut and weak global demand.  The sharp decline in commodity prices, led by crude oil, resulted in the lower realization of exports. The Chinese exports declined both value and volume as weak global demand continued to put downward pressure on exports volume.

Second major development was substantial gains of US dollar against major currencies. In times, when major central banks were adopting the ultra-eased monetary policy to support their economies; the US FED started to prepare the markets for US interest rate hike. This diverging monetary policy stance resulted in strengthening of US dollar index, which gained nearly 20% from pre July 2014 levels. Since the Chinese Yuan was more or less pegged with US dollar, it also gained substantially against its trading partners. As Chinese Yuan started losing its competitive advantage the export demand started to shift to competitive economies.

Pulling the Trigger:

The Chinese economy, which has been facing structural slow-down amid the lack of domestic demand, came under further pressure amid the consistent decline in export earnings. The Chinese authorities have been highly proactive on both fiscal and monetary front to fuel the growth. The People Bank of China has cut the benchmark interest rate multiple time and lowering margin requirement to increase the investment activity. On the other hand, the government pledging billions of dollar to stem the free-fall Equity markets.

The Chinese authority finally pulled the trigger after the release of July’s export earnings data, which declined more than 8% on Y-o-Y basis. On 11^th August, People Bank of China announced that it will allow market forces to drive the value of Chinese Yuan. As per the new policy the Chinese intervention will be substantially reduce but intra-day movement will remain in a range of 2% from central rate. Interestingly authorities retained the right to set central parity foreign exchange rate, though it will consider the market forces before deciding the central parity exchange rate.

The Major Asian currencies including rupee, witnessed sharp depreciation in line with Chinese Yuan. The offshore Chinese Yuan (CNH), which does not regulated by China, fell more 6% in just three days; sending ripples in major financial markets. During same period, The USD/INR pair also joined the party and gained nearly 2% to its 23 month high levels of 65.23 levels. Though, there is a little doubt that rupee will continue to take cues from movement in Yuan but one must not forget the state of India’s macro-economic conditions. “Right now the street’s running around with its hair on fire, but the storm always passes and Rupee will stand strong on other side”

Can We Trust China?

The current change in foreign exchange policy is win-win situation for China as it will serve two key purposes. One fall in Chinese Yuan would boost the exports and second, Chinese authority maintained that its new foreign exchange policy regime is a move towards free-float currency, which would lead to inclusion of Yuan among the IMF’s reserve currency.

When a cricket team captain dictate bowler on every single delivery, do you trust him when he says “he allows bowlers to set fielding”. Same is case with China – The China has micro-managed its equity markets it would be pre-mature to trust China, when it says it will allow market forces to drive in currency.

Food for thought - In January, Switzerland National Bank had suddenly removed the EUR/CHF floor rate creating ripples in currency markets, which lead to major defaults across the world. But in hind sight, the SNB took the right decision as ECB announced monetary easing program me, hence it would very difficult to protect the floor prices of EUR/CHF pair.  Similarly, the move by Chinese central bank can also be seen as preparation for US interest rate hike.

Source : Bloomberg, People Bank of China