Hedging The Wrong Currency

Currency ETFs have been in the news recently, largely in the US market and largely as a means of hedging against dollar depreciation.

Over the last two months, US investors have invested US$400 million in the currency ETF sector, which mainly consists of funds designed to benefit from the US currency’s fall. In the CurrencyShares range, the Aussie dollar, euro, Canadian dollar, yen and Swiss franc funds have collected the most assets (in that order), which gives some indication of investors’ preferences.

But are investors focussing on the wrong currency when seeking to protect themselves? The US dollar’s problems are well known, but there may be another global currency in even greater peril – the euro.

Why the euro? Take a look at the two charts below, which I’ve reproduced from Willem Buiter’s Maverecon blog in the Financial Times (to read Buiter’s blog, click here).

The “narrow” and “broad” classifications refer to the number of trade-weighted currencies against which the euro’s level is measured: 12 and 41, respectively. The “real” versus “nominal” measures are those adjusted for inflation and those stated in headline terms (without adjusting for inflation differences between different currency regions). Buiter has used a “synthetic” exchange rate for the period before the euro came into existence.

Whichever way you look at it, the European single currency is trading at historic highs and it’s no wonder that a leading advisor to France’s President Sarkozy referred to the current exchange rate against the US dollar – around 1.50 – as “a disaster for the European economy and industry”.  Long gone are the days shortly after the euro’s introduction when currency traders referred to it as the “zero”.

In his blog, Buiter attacks the European central bank for inflexibility and for showing a preference for deflation rather than inflation. To be fair to the ECB, there’s not a huge amount that can be done from here on the rate-cutting front given that policy rates are already close to zero (1% for the main refinancing rate, 0.25% for the deposit facility for banks), although Buiter recommends a cut to negative territory for the latter.

Given that the year-on-year change in Eurozone inflation has registered as a negative figure for four months in a row, we’re already settling into deflationary territory. Add in an unemployment rate at a ten-year high and capacity utilisation at a record low across the region (70%) and the case for a prolonged period of falling prices seems even stronger.

Although the ECB has so far toughed it out, there must be a serious question mark over how long recent currency strength can last. Perhaps US holders of euro currency ETFs and those invested in euro-denominated assets should start looking for an exit strategy, or at least a hedge.

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