by Don Alexander, MBA
Associate, RSD Solutions Inc.
The euro has rallied against the US dollar last week ending the week just below 1.39. This rally does not appear related to yield differentials. Current Euro-US short-dated bond rate differentials would suggest a weaker euro against the dollar. Economic fundamentals and market sentiment are clearly out of line and pose potential currency risks.
Bond investments tend to be one of the largest cross border flows. Any divergence between currency values and rate differentials suggests that decisions to buy and sell currencies may be related to other factors. It is possible that as European banks may be repatriating funds in anticipation of reducing their balance sheets. The rising losses on Greek sovereign debt and bank share trading below book value limit flexibility in raising funds from private investors. This suggests that shrinking the balance as one method to meet capital requirements.
When banks start a deleveraging process, the first adjustment is made to overseas business that is considered non-essential. A second adjustment may occur when banks attempt to reduce their short-term funding requirements, especially in non-core currency markets away from the euro. In particular, this could impact trade finance and commodity finance where European banks are major players.
The fact that the euro/dollar is not trading in line with rate differentials suggest other factors may be supporting the euro. This has allowed the euro to withstand selling pressure against the dollar. This may allow the euro to be well supported against the dollar as long as repatriation flows continue. As banks reduce their balance sheets, the impact is deflationary for markets and negative for asset prices. The impact of European bank deleveraging and potential credit rationing could have a strong impact on European growth prospects.
Therefore, the prospect of weaker growth prospects and the gradual ending of financial institutions repatriation could spell weakness for the euro as economic fundamentals start to reassert themselves. What is your hedging strategy?
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