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