Investors throughout the world are continually told not to "fight the Fed". But, as the consequences of the European Central Bank's recent easing unfold, investors would also be ill-advised to fight the ECB.
Carry traders -- who borrow money cheaply in liquid markets and lend it out at higher rates overseas -- have found a new friend in the ECB, which recently slashed its deposit rates to below zero. When the euro zone's central bank finally reverses its easing program, and traders are forced to unwind leveraged positions, investors should look at it as a major turning point in the current global financial cycle.
Few borrowing cycles end without incident. However, investors should remember that the unwinding of carry trades can be especially brutal -- with sometimes violent dislocations in currencies and rates.
Investors saw it in the 1990s and again in the 2000s with hedge funds backing their credit positions using the Japanese yen. They saw it in the build-up to 2007 with Swiss franc mortgages funding house purchases in eastern Europe. And they have seen it again more recently, with ultra-loose monetary policies in the US in particular funding credit investments in higher-yield countries such as Brazil.
Investors would do well to recall that all of these carry trades ended with considerable volatility. The most recent example of such an unwind came with last year's "taper tantrum," as the prospect of tighter monetary policy from the U.S. Federal Reserve presaged an era of slower growth in many emerging markets.
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In the years ahead, with a combination of interest and trepidation, investors will need to watch the surge in euro-denominated bond issuance. This year, Brazil and Israel made their first issues of euro-denominated debt maturing in eight and four years, respectively. Recent months have also witnessed the first ever sale of euro-denominated bonds by an Indian non-financial company. In total, emerging market corporations have issued $60 billion in euro-denominated debt so far in 2014, versus $25 billion at this point last year.
The deals appear attractive from both a supply and a demand perspective. On the demand side, euro-denominated fund managers are obviously looking for the next source of yield now that those on offer from Italian and Spanish bonds have reduced. And on the supply side, ECB President Mario Draghi's pledge to keep base interest rates lower for longer means that benchmark borrowing costs in the euro zone are attractive relative to the US.
But investors should not forget that such deals are simply building towards the next great carry trade unwind – but this time in euros. Like all carry trades, it will build gradually before being sharply unwound. The consequences will be multi-fold.
In the near term, the trend is likely to make itself most evident in the relative strength of the US dollar versus the euro. The euro carry trade seems to be gearing up at the same time as the US dollar carry trade is winding itself down, with the Fed tapering quantitative easing and preparing for its first rate hike.
Over the long haul, investors must prepare for a possible transformation in global funding, whereby the euro gains a larger share of global financial assets at the expense of the US dollar. Today, the euro-denominated corporate bond market is only around a third the size of the US dollar market, but seems sure to grow in relative size given the interest rate situation. This would be ironic given that the low rates which are spurring euro-issuance stem from the region's sluggish activity.
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In the end, the carry trade will unwind, most likely sparked by an eventual ECB rate hike. For now this prospect seems distant, but it could prove to be the most important rate hike in this economic cycle. Recall that it was hiking from the Bank of Japan in 2006 and 2007 and subsequent yen strength which first began to shake global markets in the build-up to the subprime crisis.
Although the euro unwind is unlikely to be as dramatic, preventing the build-up will be difficult. The euro zone needs low interest rates to prevent deflation, and the temptation of borrowing cheap has repeatedly been shown to be too great to resist. In the years ahead, it will be critical for investors to watch the correlation between euro weakness and the strength in risky assets. Only this way can they understand where the money is pouring from, and prepare for its eventual unwind.
Mark Haefele is global chief investment officer at UBS Wealth Management and Kiran Ganesh is cross-asset strategist at UBS Wealth Management.