International investors have rediscovered a love for Europe after a year's hiatus--but this time, they love the euro too.
Once, investors who wanted to bet on Europe's stocks and bonds often did so while hedging against sharp changes in the euro--a sign they weren't confident about the currency. But this year so far, $13 billion has flowed into American exchange-traded funds focused on European equities without any such safeguards. For their hedged peers, inflows have run to a mere $275.4 million.
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In the first half of 2015, when investing in Europe was last popular in the U.S., $32.7 billion entered the same group of Europe-focused ETFs domiciled in North America. Of that, 63% was hedged against currency risk.
"It looks like North American investors in particular have regained their appetite for European investments," said Simon Colvin, research analyst at IHS Markit. "In Europe we're now seeing a lot more political clarity, and there's been an overwhelming preference for unhedged products."
The risk that anti-euro nationalist Marine Le Pen would triumph in France's presidential election has now been removed, lifting a political obstacle to buyers.
Unlike the last time European equities became popular with U.S. buyers, the euro has appreciated recently, magnifying returns for American investors who haven't hedged their exposure to shifts in currency markets.
The Euro Stoxx index, which is priced in euros, has returned 12% since the start of 2017. But because of the rise in the European currency's value, for U.S. investors exchanging their euro returns into dollars, it has returned 19%.
The decision not to hedge is now fueling the recent rise in the euro, and helps explain why the currency has broken a traditional relationship with interest rates and bond yields.
When a U.S. investor buys European assets, they need to buy euros to acquire them, which drives up the value of the currency.
But if they hedge their foreign-exchange risk in the forward market, they agree to sell euros at a specified dollar price in the future--effectively canceling out the original purchase, and muting the impact on the exchange rate.
So despite massive inflows to European stocks during the first months of 2015, the euro actually fell, to as low as $1.05 in March 2015 from around $1.216 at the end of 2014.
This time around, the euro has rallied with inflows, and the currency's conventional relationship with interest rates and bond yields has weakened.
The gap between U.S. and German 10-year government bond yields has barely changed since the week before the first round of the French presidential election, when U.S. two-year yields were 2.07 percentage points above their German peers. On Monday, the yields were 2.06 percentage points apart.
But during that time the euro has risen by more than 5% against the dollar, climbing above $1.12.
Currencies tend to track differences in bond yields because the yields work as a proxy for expected interest rates. Investors tend to move money to areas where interest rates are higher, driving the domestic currency higher.
One reason why interest-rate expectations have barely budged despite investors having piled into European stocks is that growth seems to be firming more quickly than inflation in the eurozone.
Without a pickup in inflation, the European Central Bank may feel in no rush to raise interest rates to meet its target for near-but-below 2% inflation.
"It drives capital inflows into equities if you see an economy doing well, but you have this divergence between growth and inflation," said Goldman Sachs strategist Christian Mueller-Glissmann. "It depends how much the ECB cares about growth, relative to how much they look at core inflation, which is still muted."
The ECB expects growth of 1.9% this year and 1.8% next year, but for inflation to reach just 1.2% and 1.4%--in June, it raised its growth forecasts, but cut its outlook for inflation.
U.S. speculators seem to expect the euro to continue rallying. According to the Commodity Futures Trading Commission, investors have the most bullish position against the single currency in over six years, with 74,009 more long than short contracts on the euro registered in the week to June 9.
Write to Mike Bird at Mike.Bird@wsj.com
(END) Dow Jones Newswires
June 14, 2017 09:56 ET (13:56 GMT)