Euro Takes Hit From 'Carry Trade' By NEIL SHAH

The euro already faces a sea of troubles, but it could confront one more: It is becoming a favorite funding currency of the "carry trade."

Analysts at Royal Bank of Scotland Group PLC and French bank BNP Paribas SA expect the euro to suffer at the hands of the carry trade, one of the riskier investment strategies in the currency market. Such trades involve borrowing money in countries such as Japan, where interest rates are low, then investing it where rates are higher and pocketing the difference.

How the Carry Trade Works

Carry trades usually put downward pressure on the currency that is borrowed while turbo-charging the currencies that are purchased. That suggests investors may continue punishing Europe's currency, which already is down 14% against the dollar this year, even if Europe's sovereign-debt jitters abate.

"The euro is the clear-cut funding currency of choice," said Alan Ruskin, currency analyst at RBS, in a report this month. "The market senses the mess. Participants understand that monetary union is in a jam." Mr. Ruskin expects the euro to fall to $1.1650 by the end of this year.

Monday afternoon in New York, the euro slumped against the dollar and some other currencies, ending last week's rally that saw it climb from a four-year low of $1.2142. Monday, it was trading at $1.2406 from $1.2574 late Friday, and it also was down against the Australian dollar and Canadian dollar.

To be sure, investors aren't doing carry trades the way they used to before the crisis. At the height of the boom, calm markets allowed hedge funds to make big bets with borrowed money on relatively small differences in expected interest rates. By contrast, today's carry trades are just bets on the global economic recovery: You invest in, say, Australia or Brazil—countries rich with commodities that do well when economic growth is strong—and finance yourself as cheaply as possible, usually through Japanese yen or U.S. dollars.

Tobia Kleinschmidt/European Pressphoto Agency

It is hard to find actual data proving that investors are doing carry trades or using specific currencies. But last week's swings in the exchange rate between the euro and the Australian dollar, a currency that had been soaring because of its link to fast-expanding China through commodity sales, provide some evidence that investors are using euros to finance bets.

"One of the most popular trades in [currency] markets since early 2009 has been to sell the euro versus commodity [currencies], for example, the Australian dollar and New Zealand dollar," analysts at Dutch bank ING Groep NV said in a note Monday. "Last week saw an abrupt reversal of this trend."

The euro jumped some 8% against the Australian dollar last week as investors closed out these trades, which meant buying the euro and selling the currencies on which they bet.

The euro area still doesn't offer the cheapest borrowing costs compared with the U.S. and Japan. For one thing, the European Central Bank, which handles monetary policy for the 16-nation euro zone, keeps its benchmark interest rate at 1%, above the Bank of England's 0.5% rate and the Federal Reserve's range of zero to 0.25%. The cost of borrowing dollars for three months in the interbank lending market also is lower than that for borrowing euros.

But some investors are starting to see the euro as a potential borrowing tool.

"There is much more competition for funding currencies now," said Ken Dickson, a currencies portfolio manager at Standard Life Investments in Edinburgh, which manages some £146 billion ($211 billion) in assets.

There are several reasons for this shift. First, Europe's economic growth remains sluggish and likely will lag behind that of the U.K. and the U.S. next year, analysts said. The euro zone's debt crisis, along with austerity measures announced in Greece, Ireland, Spain and Germany, may further hamper growth.

That, in turn, suggests the ECB may keep interest rates lower for longer to nurture the region's recovery, Standard Life's Mr. Dickson said. Currency investors prefer higher interest rates because these boost returns. Inflation, meanwhile, remains low in Europe, which suggests the ECB won't necessarily be under pressure to raise interest rates.

Making things worse, the ECB's decision to start buying government bonds of weak euro-zone countries to prop up their funding efforts has increased doubts about the future of the euro zone itself. This is why many analysts are now bearish about the euro, with French bank BNP Paribas, the gloomiest of the bunch, betting the euro will reach parity and even lower against the dollar early next year.

At the same time, the U.S. dollar and the yen, the usual carry-trade currencies, are jumping in value as investors rush into safe havens, making it more difficult to borrow in them.

The euro hit $1.50 late last year, a level that analysts and European policy makers have deemed too high. Many consider the euro's "fair value" against the dollar to be about $1.25, roughly where it is now. From this point of view, the currency simply has come back to reality.

But analysts warn that the emergence of euro-funded carry trades may mean that even if better news about Europe materializes in the months ahead, the currency may stay under pressure for months to come.

~Katie Martin contributed to this article.