Euro ETF Impact On Surprise ECB Rate Cut

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November 11, 2013 3:31pm NYSE:ERO NYSE:FXE

europeThe European Central Bank (ECB) surprised the global market on Thursday with its decision to cut its interest rates. The bank slashed its benchmark interest rate by a quarter percentage point to a record low 0.25% in order to support Euro zone growth.

Marginal lending rate was also reduced to 0.75% from 1% while deposit facility rate remains unchanged.

Behind the Rate Cut

Though the Euro zone emerged from an 18-month recession in the second quarter with 0.3% expansion, the recovery still seems fragile. Tumbling inflation and higher unemployment might stall the burgeoning Euro zone economic recovery.

Inflation fell from 1.1% in September to a record low of 0.7% in October. The number is also well below the ECB inflation target of under 2%. Unemployment across the Euro zone remained at the record high of 12.2% in September (read:Europe ETF investing 101).

The European Commission (EU) expects unemployment in this 17-country bloc to remain near the record high until 2015 while inflation would be at lower levels of 1.5% this year and could further drop to 1.4% in 2015. This suggests that the Euro zone might experience a prolonged period of low inflation.

Thanks to weak private demand and investment, the agency sees the economy shrinking 0.4% this year, and slashed its economic growth outlook from 1.2% to 1.1% for the next year.

Euro Zone Grows Slow

Still, various data points suggest that the Euro zone is gaining momentum albeit at a slower pace despite low inflation and elevated unemployment.

Economic and business confidence is rising in the 17-country bloc, indicating a new era of growth for the continent. In fact, the confidence indicator continued to rise in October for the sixth time with growth of 0.9%.

Further, Euro zone manufacturing activity accelerated in October for the fourth consecutive month to 51.3 from 51.1 in September. Germany, Ireland and Spain recorded robust growth while France and Greece failed to expand.

In an effort to support the Euro zone’s revival, the ECB President – Mario Draghi – is committed to provide ample liquidity to banks when needed until at least July 2015.

Market Impact

The surprise move by ECB led to a sharp sell-off of the euro against the U.S. dollar. The euro fell 0.8% against the greenback on Thursday at the close after slipping as much as 1.6% on the day, which marks the biggest drop in two years.

This poor performance was also felt in the ETF world, with euro currency ETFs falling in intraday trade. This downward trend is expected to continue only for a few days if history is any guide. The euro was down nearly 3% over the past 10 days but is up 1.6% so far this year.

So investors could definitely take advantage of the current pullback and consider the following two ETFs for their exposure if you believe that the worst is over for the euro (see: all the Currency ETFs here):

How to Play?

CurrencyShares Euro Trust (NYSEARCA:FXE)

This fund is a great way to play a rise in the euro relative to the U.S. dollar. It 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.

The ETF has amassed $201.7 million in its asset base and sees a good volume of more than 420,000 shares a day. The product has an expense ratio of 0.40%. FXE generated returns of nearly 2% in the year-to-date time frame while it has lost 2.79% in the past 10 trading sessions (read: Play a Resurgent Europe with These ETFs).

iPath EUR/USD Exchange Rate ETN (NYSEARCA:ERO)

This fund seeks to match the performance and yield of the EUR/USD exchange rate before fees and expenses. The fund holds 100% of its assets in EUR. The product not only provides a core investment opportunity in the currency space but also enables investors holding a well-diversified portfolio, to hedge their position against foreign exchange fluctuation.

Still, ERO has failed to attract investors with just $5.8 million in AUM and less than 1,300 shares in average daily volume. This suggests that investors have to pay an additional cost in the form of wide bid/ask spread beyond the expense ratio of 0.40%. The note was down 0.23% in the last 10 days while it has added 0.67% in the year-to-date period.

This article is brought to you courtesy of Eric Dutram.

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