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The European Central Bank (ECB) took its first step in ten months to avoid falling into a deeper recession by cutting its benchmark interest rate. The interest rate, which was last changed in July 2012, has now been reduced by a quarter percentage point to a record low of 0.50%. Also, the marginal lending rate was reduced to 1.0% from 1.5% (Euro Small Cap ETFs: The Way to Play Europe?).
In fact, the ECB President has promised to provide ample liquidity to Eurozone banks until next July in an effort to support the recession hit economy. It also seeks to support smaller companies which were affected by poor liquidity condition. However, it seems that steps taken by the ECB would have little impact on the economy in the short term.
The move comes in after a reduction in inflation from 1.7% to a three-year low of 1.2% in April and unemployment hitting its highest level. Joblessness remains at elevated levels across the 17 eurozone states recording above 12% including a Spanish rate of nearly 27% (Italy ETF Plunges on Election Chaos).
Also, euro-zone manufacturing activity contracted at a slower-than-forecast pace in April, with the manufacturing PMI falling slightly to 46.7 from 46.8 in March. It seems that the weakness in the commodity market is putting pressure on inflation.
The ECB now expects the economy to show an improvement in the second half of the year. But with such poor economic data, recovery even in the second half of the year appears elusive. In fact, it appears that the scars of deep euro-zone recession are now visible in Germany as even that nation may now be slowing.
Impact on Euro
The euro fell more than 1% after the ECB lowered its rates. The currency initially traded above $1.32 but with the new rate announcement, the currency dived down. The fall came in after ECB said that it is quite optimistic on the idea of lowering the deposit rate (Bet on the Euro with These 3 ETFs).
Currently, the economy has a deposit rate of 0%. Further deterioration will lead to negative deposit rate for banks, so there could be some added pressure on banks to lend money soon.
Still, the euro had a good last month gaining around 3%. In fact, in the last five trading sessions before the announcement, the currency has been gaining strength despite the news of the possible rate cut by the ECB.
Impact on ETF
The Currency Shares Euro ETF (FXE) has been designed to track the performance of the euro versus U.S. dollar (USD). The ETF recorded a fall of almost 1% immediately following the ECB’s announcement.
Launched in Dec 2005, this ETF tracks the movement of the euro relative to the USD, net of the Trust expenses, which are expected to be paid from the interest earned on the deposited euros.
This fund appears to be a great way to play any rise in the euro relative to the U.S. dollar. The product generated a negative return of 0.69% in the last one year while it has lost 0.74% year to date.
In terms of the fund’s structure, the product charges 40 bps a year in fees. Additionally, the ETF sees a good volume of 560,000 shares a day and has attracted $272.1 million of assets so far. As a result, the average bid/ask spread is quite small, suggesting low overall trading costs (Has the Euro ETF Bottomed Out?).
After the Cut
History reveals that such interest rate cuts have a very short-term downside impact on euro currency ETFs, and this was definitely the case for FXE recently. The fund rebounded after the initial swoon and some added Draghi comments to rebound to pre-interest rate cut levels in no time at all.
So, this may be a time to buy FXE on dips and later sell when the currency gains strength. Investors could therefore consider repositioning their portfolios to take advantage of the rising euro against the USD, at least in the short term.
Also, investors who foresee this happening, and are expecting the currency to rise going forward, can look to invest in the Market Vectors Double Long Euro ETN (URR).
Launched in May 2008, this note seeks to track the performance of the Double Long Euro Index, net of fees and expenses. The index provides two times daily leveraged exposure of the euro relative to the USD (Is the Dollar ETF About to Surge?).
In other words, for every 1% appreciation in euros relative to USD, the index will increase by 2%.
Due to its double leverage and short-term focus, this ETN involves a great deal of risk. Furthermore, investors should note that the note has failed to attract investors so far, as AUM is below $1 million.
The product does have a relatively low cost for a leveraged fund at just 65 basis points a year, though it is hard to say if this will make up for such poor volume levels. Recent trading has been pretty hurtful to this ETN, as it is now down about 1% YTD.
Either way though, it appears that the euro has taken the latest rate cut in stride, even with the prospect of further cuts in the future. This suggests that sluggish trading could continue for this currency in the near term, but that huge losses aren’t likely unless events really take a turn for the worse.
For this reason, we keep our Zacks ETF Rank of 3 (Hold) on the fund, and suggest that investors may want to look elsewhere for big currency moves now that the rate cut has passed.
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