ECB policy is carry-trade-tastic: James Saft

September 4, 2014

Sept 4 (Reuters) – For all the uncertainty around the
European Central Bank’s extraordinary monetary policy, one thing
is for sure: it’ll be good for carry trades.

If an asset has a higher yield than euro-denominated ones,
and in today’s world many, many do, it will benefit from
increased flows from investors borrowing in euros and making
bets elsewhere. Notable beneficiaries will be emerging markets,
but the fun hardly stops there.

The ECB on Thursday made a slate of moves to react to
weakening growth in the euro zone. Three policy rates were cut
by 10 basis points, leaving the deposit facility at negative 20
basis points, in a move the ECB signaled was the end of the road
for conventional easing.

Also unveiled was an asset-backed security purchase program,
to be launched and detailed in October and to be accompanied by
a similar plan to buy covered bonds. All of this apparently
moves us closer to outright quantitative easing, with sovereign
bonds being bought on the secondary market.

This all was probably justified, and might even work. Or
help, at any rate, though the list of provisos and limitations
to monetary policy effectiveness in the euro zone is long.

What cannot be disputed is that money funded in euros will
get cheaper, though infinitesimally, and some cash now parked by
banks may move off of the sidelines, put to work in those
projects or speculations bank clients care to make.

A few basis points here or there may not make a huge
difference to the decision of a German middle-market company to
invest in new machinery, but certainly will disproportionately
benefit leverage-intensive activities, like say, borrowing short
in euro and going long emerging markets.

“To the extent that at least some part of that money will
head abroad, the turbo-charged easy money will likely invigorate
euro-funded carry trades,” Citigroup foreign exchange strategist
Valentin Marinov wrote in a note to clients.

“As a result, foreign investors buying euro-denominated
assets would be hedging their downside risk more aggressively.
Last but not least, stronger domestic demand in the Eurozone on
the back of the ECB measures could lead to deteriorating
external imbalances and weaken the euro.”

The euro will weaken, as indeed it already has, and
financial markets globally will get a bit of a fillip, at least
until the outcome of the Fed’s rate hike discussion is known
later this year.

MONEY IS FUNGIBLE

Indeed, the ECB’s move was big enough and unexpected enough
that it very possibly will make Friday’s U.S. jobs report just
that little bit irrelevant. We are highly unlikely to get a
result on Friday that is as surprising as the ECB’s slate of
moves, meaning that we should definitely end the week in a more
bullish mood toward risk than we started.

“Today was a huge day for global markets. The ECB sent a
much more powerful message than had been anticipated, killing
the policy disappointment risk in the process,” emerging market
strategist Benoit Anne of Societe Generale wrote to clients.

“You can now all relax and enjoy another strong leg of this
emerging markets rally. Yes, this rally will end at some point
-although not anytime soon – but the ECB has just given it a new
breath of life.”

So, good news for risk-taking and for financial assets, but
what of the longer term?

Financial markets are in receipt of a major surprise boost
to risk-taking, something which happens arguably all too
frequently.

Indeed, in the years since the acute phase of the financial
crisis, we’ve had one extraordinary boost to risk after another:
QE1, QE2, QE3 in the U.S.; various alphabet soup initiatives by
the ECB; Abenomics in Japan.

Each time risk-taking is boosted, but evidence that the
underlying economy benefits in proportion is far from clear.

It isn’t so much that it is wrong to put in place a policy,
as the ECB, Fed and Japan have, that has speculative flows as a
side effect. Rather the concern is that the immediate
beneficiaries of those speculative flows get their share with a
high degree of certainty, while the rest of us wait around to
see if the economy will recover.

In the euro zone, with its awkward arrangements and
dependence on unlikely reforms, that is far from a sure thing.

Enjoy your carry trades while you can.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be
an owner indirectly as an investor in a fund. You can email him
at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by Dan Grebler)

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