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Emerging markets may become new force in euro rally: Goldman Sachs

Hannelore Foerster | Getty Images

Emerging market central banks could become as a new force that underpins the euro rally, according to Goldman Sachs.

In the second quarter, emerging market central banks increased their reserve portfolio allocations to the euro for the first time since mid-2011, the bank said. The share of euro holdings rose to 23.8 percent of allocated reserves from 23.6 percent. This compares to a record high of 30.8 percent in mid-2009 just before the euro zone debt crisis began to unfold.

"While the increase is tiny, it coincides with the first signs of a growth recovery in the euro zone. If the increase in the share of euro holdings is the beginning of a new trend, central bank activity could become a euro supportive factor after having been a drag on the euro in the latter part of the euro zone crisis," Thomas Stolper, chief foreign exchange strategist at Goldman Sachs wrote in a note on Monday.

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The euro has gained around 6 percent against the U.S. dollar since the start of the second quarter, boosted by capital inflows into the region's bond and equity markets in recent months amid signs of stabilization in the single currency bloc.

Another indication of increasing confidence in the euro, Stolper said, is that emerging market central banks appear to have resorted to selling U.S. dollars to support their domestic currencies during the recent currency crisis, instead of euros.

"With the euro-dollar being a very liquid cross, emerging market central banks could certainly have reduced their euro holdings by selling euro-dollar in the most liquid FX market globally. The fact that this has not happened could therefore be seen as [the] first sign that emerging market central banks… have a little more confidence in the euro," he said. As of the second quarter, emerging market central banks held about 60.9 percent of their allocated reserves in U.S. dollars.

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Mitul Kotecha, head of foreign exchange strategy at Credit Agricole said a bottoming out in euro zone economies and reduction in systemic risks has been sufficient to warrant a return of capital from central banks to European assets.

"Central banks are becoming more interested in European bonds, it's not a surprise that they have increased their allocation to euro zone assets," he said. "Admittedly, central banks don't want to be over exposed to Treasurys, so they will look to other assets."

However, Kotecha said he doesn't foresee a sizable increase in allocation to European assets going forward, noting that central banks are also looking to other bond markets elsewhere in Asia, as well as Canada and Australia.

(Read more: Emerging markets thrive amid US shutdown)

Nevertheless, he anticipates that a steady pickup in euro accumulation will provide positive momentum to the currency given the sheer size of central bank flows.

Sean Callow, senior currency strategist at Westpac added that a substantial shift into euros by emerging market central banks would be a "very powerful offset" to those who are bearish on the currency due to the region's sluggish growth environment.

—By CNBC's Ansuya Harjani; Follow her on Twitter @Ansuya_H