2012 can see a global equity market rally with euro as the carry trade currency

The euro is exhibiting signs of becoming a carry trade currency. Carry trade is when markets borrow in one currency to fund the purchase of assets in another currency. The end result is a general weakening of the funding currency and rise in prices in some asset classes.

[caption id=“attachment_177207” align=“alignleft” width=“380” caption=“Carry trade is when markets borrow in one currency to fund the purchase of assets in another currency. Reuters”]  [/caption]

In the last one month the euro has fallen by over 5 percent against the US Dollar. Euro has come off from $1.34 to $1.27 since the beginning of December 2011 to date. Equity indices in the same period have been positive to mildly negative across geographies. US and European indices have gained over the last one month even as the euro fell to one year lows. A one month trend may not be a precursor to the future, but looking at the fundamentals of the euro, the trend may well continue. The trend of a weakening euro and rising equity prices is a good possibility for the rest of 2012.

The fundamentals of the euro have weakened considerably over the last few months. A large part of the euro’s strength was derived from the fact that the ECB’s (European Central Bank) sole mandate was inflation targeting. The mandate has not formally changed but the ECB is now getting sucked into the debt problems plaguing eurozone countries. The move by the ECB to lend unlimited funds for three years at 1 percent to European banks is an indirect effort to bail out debt-ridden countries that are unable to refinance debt. The last auction of funds in December 2011 saw banks borrowing close to 500 billion euros from the ECB.

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ECB has consistently been expanding its balance sheet since 2008, when the credit crisis forced central banks to lend against securities to stem a liquidity crisis. The debt problems of eurozone countries have forced the ECB to buy bonds of the debt-ridden countries of Italy, Spain, Portugal and Greece. ECB’s assets have grown from less than euro 1.4 trillion in 2008 to euro 2.7 trillion in 2011. A central bank pumping liquidity into the system is a cause for currency weakness.

The ECB has cut interest rates from 1.5 percent to 1 percent over the last two months. The eurozone debt issues and the resultant threat to growth as governments adopt austerity measures to cut debt prompted the cutting of policy rates. The fall in eurozone inflation to 2.8 percent in December 2011 from 3 percent in November 2011 is an indicator of falling inflation expectations. Unemployment is at over 10 percent levels in the eurozone and forecasts of a mild recession this calendar year will not help in improving job prospects. The ECB will have to cut rates further to prop up the eurozone economy.

In contrast to the eurozone economics, the US economy is looking much better. The latest numbers coming out of the US is positive with manufacturing growth for December 2011 at six month highs and unemployment rate coming off to 8.5 percent. The US has been continuously adding jobs albeit at a slow pace with December 2011 seeing job additions of 200,000. The US Federal (Fed) has pledged to maintain interest rates at zero percent till 2013 and this will help the US economy grow at a better pace than the eurozone. Markets will look at rising growth differentials between the eurozone and the US and will take down the euro further against the dollar.

An equity market rally across the globe with the euro as the funding currency is well on the cards. Low eurozone interest rates and high liquidity from the central bank will can act as a catalyst for carry trades. Commodities may not rally on the back of a strong dollar.

India can benefit from a global equity rally driven by cheap euro funding. Interest rate differentials work in favour for India as policy rates are 750bps above ECB rate of 1 percent. Growth differential also works in favour for India as it is growing at 7 percent against a zero or negative growth in the eurozone. Stable to weak commodity prices on the back of a strong dollar will benefit India as it brings down inflation expectations.

The markets are now in completely unknown territory and established fundamentals have broken down. Hence a rally led by euro will be new to the markets and it remains to be seen how it will pan out.

Arjun Parthasarathy is the Editor of www.investorsareidiots.com a web site for investors.