Even with the euro touching two-year lows, the currency faces even more pressure

07/12/2012 6:26 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Could the euro take another hit if China’s second quarter GDP numbers—due for release Friday—disappoint? That was a theory making the rounds of the currency desks today, Thursday, July 12.

The euro closed today at $1.2197, down another 0.05% and not far off the 52-week low at $1.2167. In later electronic trading the currency reached a 2-year low.

Besides all the troubles with European economies and increasing speculation that the European Central Bank will cut its benchmark interest rates again—hard on the heels of the bank’s rate reduction to 0.75%--foreign exchange traders have begun to believe that a drop in China’s foreign exchange reserves—because of slowing growth in China--could mean an even steeper decline for the euro.

The thinking goes like this: Data released on Thursday, July 12, show that China’s foreign exchange reserves for June came in at $3.24 trillion, roughly $110 billion lower than expected. That means China will be buying fewer dollars, and yen, and euros to store in its vaults. With the euro slipping anyway due to the euro debt/Spanish debt crisis, a deepening EuroZone recession, and bets that the European Central Bank will cut interest rates again when it meets on July 19, falling demand from China would be enough to push the currency below its two-year low.

This kind of thinking has a way of becoming a self-fulfilling prophecy. Traders have added the euro to their list of carry-trade currencies recently. (“Carry trade” describes the practice of borrowing in a low-yield currency and then using that borrowed money to invest in higher yielding currencies.)

Which is, if you think about it, a very big vote on no confidence in the euro. Although it costs very little to borrow in euros, it still costs more than it does to borrow in yen or dollars. But a trader using this strategy doesn’t care just about the interest rate on those borrowed funds. The trader would also like to find a currency that will fall in value during the term of the borrowing so that when the debt is repaid, it is repaid in cheaper yen or dollars or, now, euros. If the carry trade is willing to pay a higher interest rate to borrow in euros than in yen or dollars, it’s because traders are convinced that the euro stands a better chance of falling in value than the yen or dollar.

And because borrowing in euros to invest in other currencies means selling euros to buy those other currencies, the conviction that the euro is a good candidate for generating carry-trade profits means that the currency will face even greater selling pressure.

That pressure will get more intense if China announces a disappointing GDP number Friday—economists are projecting that second-quarter GDP growth will fall to 7.6% (the forecast was for 7.7% just a few days ago) from 8.1% in the first quarter. I can hear the gears whirring now: If China is slowing, then European economies face even more danger of slowing because European exports to China will fall, and that will make an interest rate cut from the European Central Bank at its July 19 meeting even more likely.

Would you sell euros in that scenario? You bet.

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