Euro Exchange Rates to Suffer as Investors Reignite Love-Affair with Emerging Markets

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Investors are turning to high-yielding emerging market assets once more according to research by Italian lender UniCredit and the IMF - this spells potential weakness for the euro going forward.

  1. Demand for emerging market assets is growing, the euro should be a loser of this dynamic
  2. Euro / dollar expected to remain caught in long-term sideways trend
  3. Euro / pound to suffer further declines

The amount of money flowing into risky portfolios, composed of wider global assets, has increased. 

This growing trend is likely to impact negatively on both the euro and the US dollar which are highly the target currency used to fund investor forays into exotic locations. 

“Something good is going on! After much huffing and puffing, investors are again moving towards riskier assets," says UniCredit Bank’s global chief economist Erik Nielsen in London, "EM-dedicated bond funds saw the largest inflows since June 2014 during the week to 7 April, followed by the second largest inflows last week, at USD 1.6bn.”

We now have four weeks of net positive flows, “with the four-week moving average climbing to USD 1.35bn, the highest level since February 2013.”

Nor is the rally higher just a ‘random event’ but rather it is representative of a stabilization of emerging markets in general:

“The recent weeks’ move towards riskier assets is not a random event, but rather markets smelling a change that is likely to be more fundamental, namely the stabilization in EM, which in turn reduces the risk to the OECD area.”

Impact on the Euro

The euro is a popular funding currency used by investors purchasing higher-yielding riskier assets – such as emerging market bonds.

The euro benefits from being ultra-cheap to borrow and its easy liquididity makes it one of the world’s reserve currencies.

The euro’s recent lack of upside momentum, which has occured alongside a global stock market rally, may be in part due to a these dynamics becoming more entrenched.

If Nielsen's predictions are right then the euro may see a cap on its gains.

However, against the US dollar we would expect the long-term sideways move to extend as the USD is exposed to the same 'funding currency' demand as the euro. 

This may mean the EUR/USD is caught in an extension of the sideways trend it has  been in since March 2015.

However, there is also the argument to be made that improved global sentiment may be more bullish for the dollar, since an improvement in global growth prospects would be expected to improve the prospects for the US Federal Reserve increasing interest rates.

The recent minutes from the March meeting, for example, made it clear that a major impediment to raising rates was the negative outlook for global stability. Higher US interest rates = higher demand for the dollar.

Could This Help The Pound to Euro Pair?

Another euro pair which may be affected is the GBP/EUR, as the pound tends to mirror the dollar in its reaction to global risk appetite.

Whilst the outlook for sterling is clouded by volatility due to the June referendum, the pair is currently pushing up against a critical trend-line, poised to break out higher. 

Further weakness in the euro could be a possible driver signalling upside for the pair on the horizon.

GBPEURApr15

IMF Report Key to Analysis 

UniCredit's Nielsen bases his analysis on a report from the International Monetary Fund which he suggests implies that the “Global Growth Slowdown” has come to an end.

“The global growth slowdown, in place since 2010, looks as if it has come to an end this year. During the “years of excess” (2002-2007), global GDP growth averaged 4.8%. Then we had the crisis and the rebound to a 5.4% growth rate in 2010, but growth has slowed ever since, reaching barely over 3% last year. This year, the IMF thinks it’s stabilizing and recovering a bit, which I think most of us would agree with.”

The newfound stabilization will be led by China who will see their growth moderate after sliding for several years in a row. Nielsen ends the note, reiterating his point:

“So here is your global growth story: After five years of slowing growth, of which the last 2-3 years have been all on account of EM, things are now stabilizing – which is good for EM, and it lowers the risk to the OECD area. That explains why some of all this global liquidity is starting to chase riskier assets again, and there is no obvious reason why that is about to end here.”