Euro Carry Trade

Will 1% loans from the European Central Bank to struggling European banks result in stabilization of the European banking system or a Euro carry trade? The European Union has been in a sovereign debt dilemma for a couple of years. The Southern tier of EU nations, plus Ireland, has become the PIIGS (Portugal, Ireland, Italy, Greece, and Spain) group. These nations, most notably Greece, would have been unable to finance their national debts without aid from lenders, the IMF, the European Central Bank and other EU nations in particular. The possibility of a breakup of the European Union or at least the departure of Greece and a couple of other nations loomed over the continent for the last few months. Just recently EU leaders met in Paris and agreed to amend the EU treaty to allow closer financial integration. (Read this as putting a cap on politically motivated pork barrel spending to buy local votes.) In addition EU members gave the European Central Bank greater authority and autonomy in dealing with the overall debt situation as many banks were weak and many considered a run on French banks a distinct possibility as many had invested heavily in bonds from Greece, Italy, and the others. But, just what does this have to do with a Euro carry trade?

The expression, carry trade, is usually associated with the Yen and not the Euro. Japan has had extremely low interest rates for two decades. Investors holding Yen can engage in foreign exchange trading and obtain US dollars or other international currencies in search of better returns on investment. Then the investor buys US Treasuries if he now has dollars or, perhaps, Italian or Greek national debt bonds if he has turned in Yen into Euros. Anyone who bought dollars before the rally last fall and then purchased treasury bills before rates fell did doubly well.

On the other hand many Japanese repatriated offshore assets to pay for the destruction of the worst earthquake and tsunami in their history. This Yen repatriation sent the currency up dangerously fast. The rise in the Yen was only halted by threats of the G7 ministers to intervene in strength. Anyone who held offshore assets in a Yen carry trade did poorly at that point. The point of the Yen carry trade is to have or borrow assets in a nation where interest rates are low, convert to another currency, and invest where interest rates are high. The point is also that a change in currency rates does not erase all profits. This is the connection to a so called Euro carry trade.

A concern of some is that struggling European banks that have received 1% interest loans may be tempted to invest in high risk, potentially high return, debt. Whether this would be European debt or to use foreign exchange trading in order to practice a Euro carry trade debt elsewhere in the world the potential for profits could be great, providing that the global economic picture brightens. On the other hand the loans could amount to throwing good money after bad if anyone tries such an aggressive and risky strategy. The good news for those fearful of such a scenario is that overnight deposits at the European Central Bank are at an all-time high. Apparently many of the European banks that needed bailouts have learned their lesson. They are avoiding any semblance of a Euro carry trade and putting their short term money in the most secure location available, even at low overnight interest rates.