Euro Becomes the Port in a Storm

As Central Banks Mull Pullback of Easy Money, Investors Turn to Relatively Stable European Currency

By MATTHEW WALTER and NICOLE HONG

The Wall Street Journal

The euro is emerging as an unlikely oasis in the latest bout of market turmoil.

Assets ranging from Japanese stocks to emerging-market bonds to U.S. Treasurys have slumped this spring, as investors brace for the possible pullback from easy-money policies by the world's major central banks. But the euro has largely avoided the volatile trading that has whipsawed other currencies, including the dollar and the Japanese yen, gaining about 4% against the greenback over the past four weeks to trade late Friday at $1.3345, near a four-month high.

It is a dramatic reversal for a currency that frequently has been at the center of global market turmoil in the past few years. Investors had put on record bets that the euro would fall, fueled by Europe's economic slump and questions about the long-term viability of the currency union.

Bearish euro positions have tumbled 90% in the past two weeks, according to the Commodity Futures Trading Commission. Despite problems that include stunted European economic growth, rising unemployment and large debt loads in southern European economies, many investors say the euro is a relatively safe bet these days, thanks to its status as a heavily traded reserve currency and ebbing fears of an imminent crisis.

The prospect of an early end to Federal Reserve stimulus has prompted many traders to hastily unwind bets on emerging markets and other high-yielding assets. As these positions unravel, some investors are taking shelter in the euro, which they see as having more in common with havens such as the dollar and yen than riskier, more thinly traded, higher-yielding currencies like the Australian dollar.

"It's hard to bet against the euro," said Sam Katzman, chief investment officer for New York-based Constellation Wealth Advisors, which invests about $5 billion in various funds on behalf of clients. "Until we stop printing money in the U.S., or they start, the wind is at the back of the euro."

Driving the euro's strength is an unwinding of the "carry trade," in which investors borrow a low-yielding currency like the euro, sell it and then use the proceeds to buy higher-yielding assets like U.S. stocks and Mexican bonds. Carry trades, which helped power solid gains in riskier asset classes for the past few years, rely on a steady interest-rate differential to make money.

But now that the outlook for interest rates is less certain, investors are scrambling to exit carry trades before central banks change course. The euro is up nearly 10% since the start of May against the Australian dollar, a popular carry-trade target.

"The path of least resistance for the euro is higher," said Bob Marcellus, managing director at Richmond Optimus, which manages $30 million and is betting the currency will strengthen.

To be sure, betting on the euro has its drawbacks. The currency's appreciation isn't a welcome development for struggling European economies, such as Spain, Portugal and Italy. A stronger euro makes European exports less attractive to overseas buyers, and reduces revenue for exporters when they convert their foreign earnings back to euros.

Also, Italian and Spanish bond prices have fallen in the past two weeks, a sign that investors still view parts of the euro zone as risky. MSCI Inc., which publishes stock and bond indexes tracked by investors managing trillions of dollars, recently reclassified Greece as an emerging market rather than a developed one.

"It makes sense from an economic standpoint that the euro should be weaker," said Jeffrey Sica, president and chief investment officer of Sica Wealth Management, Morristown, N.J.

Mr. Sica has been betting the euro will fall for two years but said holding that position has been "torturous."

"All rules have been thrown out the window," he said. "There are no fundamentals, and that's making it very, very difficult to be a trader."

The euro's strength is also at risk if the market stabilizes and investors feel more comfortable putting on carry trades again, which would mean selling the European currency.

Some investors point to tentative signs that Europe's prolonged recession may have found a floor. Euro-zone industrial production rose in April for the third straight month, led by gains in Germany and France. A leading indicator released last week by the Organization for Economic Cooperation and Development signaled a return to euro-zone growth later this year.

The improved data reduce the odds that the European Central Bank will need to loosen monetary policy at a time when the Fed is warning it may soon pull back. That preserves a crucial edge the euro has had over the dollar and yen.

The ECB has refrained from big stimulus programs, while the Fed and Bank of Japan both are buying billions of dollars in bonds every month to boost growth. Central-bank stimulus tends to hurt the local currency, by increasing the amount in circulation. Much of the euro's rise has come since the ECB's June 6 meeting, where ECB President Mario Draghi said the central bank wasn't ready to introduce negative deposit rates, a measure aimed at boosting lending that also could have triggered a drop in the euro.

"They're dealing with the economy now" in Europe, said Thanos Papasavvas, a strategist at Investec Asset Management, which manages about $105 billion in assets globally and currently holds the euro in its currency portfolio. "It will take time, but it's stable, and I think if anything it's going to be surprising to the upside."

Other investors cite as a reason to buy the euro the fact that its value has held up despite a series of challenges. The currency declined in February after Cyprus took a bailout and an Italian election failed to immediately produce a new government. But its slide to just below $1.28 in late March was mild compared with past crises that knocked the euro to $1.20 or below.

"The system has been tested a bit and it's held up," said Matthew Alexy, director of global foreign exchange at TD Securities.

Write to Matthew Walter at matthew.walter@dowjones.com and Nicole Hong at nicole.hong@dowjones.com