* After crisis, euro zone shows signs of becoming safe haven
* Current account surplus acts as comfort blanket for euro
* Signs of stronger economic growth may make ECB hesitate
* Funds flowing back from falling emerging markets
By Anirban Nag
LONDON, Feb 4 Anyone betting against the euro
may well find this strategy remains a "pain trade", even though
the common currency has fallen to a 10-week low against the
dollar this week.
This drop looks unlikely to be the long-awaited breakout in
what has been one of the world's most stable free exchange rates
and, in a remarkable change of fortunes, the euro zone is
showing signs of becoming a safe haven.
Analysts have been forecasting a weaker euro for at least
three years but, despite economic crisis within the euro zone
and even doubts the currency would survive, it has defied
expectations and traded in a relatively narrow range.
Since the end of 2011, the euro has held between $1.20 and
$1.40, supported by a widening euro zone current account surplus
and the European Central Bank's tactics which have differed
sharply from those of its peers.
While both the U.S. Federal Reserve and Bank of Japan have
flooded their markets with cash by buying bonds at a record
pace, the ECB has acted much more cautiously, reabsorbing much
of the money it has injected into the banking system.
In accountants' terms, the ECB has shrunk its balance sheet
while the Fed and BOJ are expanding theirs.
The robust euro has created its own problems. A strong euro
lowers the cost of imported goods, complicating the ECB's fight
to avoid damaging deflation in the euro zone. Consumer prices
rose just 0.7 percent year-on-year in January, less than
expected and well below the ECB's target of close to 2 percent.
Talk that the ECB might loosen policy in response as soon as
this week pushed the euro to $1.34765 on Monday. It also
hit a two-month low against the yen and a six-week
trough versus the Swiss franc.
But this weakness has been offset by inflows as investors
pull money from falling emerging markets. Far from being
threatened, the euro is seen as something of a haven.
"Trading the euro, especially euro/dollar will remain a pain
trade," said Geoffrey Yu, currency strategist at UBS. "Unless
the ECB cuts the refinancing rate and decides to expand its
balance sheet, the euro is unlikely to fall much."
Trends in the options market indicate that while investors
are betting on euro weakness before the ECB meeting on
Thursday, overall there is hardly a rush to buy
protection to hedge against a sharp drop in the common currency,
especially in six to 12 months' time.
A Reuters poll released on Monday showed traders expect the
ECB to keep monetary policy unchanged on Thursday. If that
happens, the euro will recover lost ground.
Another reason investors are not rushing to place big bets
against the euro is that signs economic growth in the euro zone
is picking up could make the ECB hesitate in easing policy.
Further, euro zone banks are still repaying crisis loans to
the ECB, cutting excess cash in the banking system, and pushing
up short-term money market rates. Higher short term rates make
the euro more attractive for investors seeking higher returns.
And lastly, euro zone banks - which according to the Bank
for International Settlements have over $3 trillion exposure to
emerging markets - seem to have started the process of
withdrawing money from those falling markets. That is likely to
underpin the euro.
Jane Foley, a currency strategist at Rabobank said these
inflows are allowing the euro zone to maintain a record current
account surplus. This stood at 23.5 billion euros in November,
up from 22.2 billion in October.
"The strength of this surplus is acting as a comfort blanket
for the euro. Even though the currency was deeply embroiled in a
crisis not very long ago, the euro is exhibiting some safe-haven
behaviour," she added.
In mid-2013, when emerging markets (EM) began to wilt after
the Fed signalled it was ready to reduce its bond buying,
investors rushed to the euro as the second-most liquid currency
after the dollar.
Foreign investors bought 250 billion euros of euro zone
stocks last year and pumped 100 billion euros into
euro-denominated money market funds, official data showed. In
January, funds began to flow out of emerging markets.
"Its recent correction lower notwithstanding, investors may
be hesitant to sell the euro further given its status of a
safe-haven currency," said Valentin Marinov, currency analyst at
This may also apply versus the "G10 smalls" - less liquid
currencies in the developed world such as the Australian dollar.
"The euro could remain supported against G10 smalls and EM
currencies if recent market volatility escalates some more,"
However, the euro could drop sharply if the ECB takes
dramatic steps such as stopping soaking up all the money it
pumps into the banking system via regular money market
operations, or cutting the rate at which banks park excess funds
with it to negative.
Until that happens, excess liquidity in the
euro zone banking sector will remain close to its lowest levels
since late 2011. And with that there is a risk that short-term
money market rates could rise.
Undoubtedly, short-term interbank rates have slipped since
late last week, but they remain relatively high and volatile,
putting pressure on the ECB to step in and pump cash.
"Short-dated rates have a good relationship with the euro,"
added UBS's Yu. "The ECB has to address the money market
problems if the euro is to weaken."