By Saikat Chatterjee and Dhara Ranasinghe
LONDON (Reuters) - Euro zone investors who have snapped up over a trillion euros worth of foreign debt without protecting the foreign exchange risk are rethinking that vulnerability because of the currency's hefty rally this year.
The move entails buying euros to hedge, which turbo charges the rally even further - creating a headwind for the European Central Bank.
The ECB is widely expected to start laying out its plans for scaling back monetary stimulus at next week's policy meeting, but a strong euro complicates this since it puts downward pressure on inflation which is already running below target.
One reason for the euro's resilience is some 1.16 trillion euros ($1.37 trillion) of foreign bonds that have been purchased by European investors since the ECB launched its quantitative easing programme in March 2015, according to estimates from investors based on official data.
They have been forced to buy non-euro debt because the ECB has been taking up much of the domestic pool of bonds.
The bulk of the non-euro purchases were bought on a currency-unhedged basis because euro weakness during the bulk of ECB asset purchases meant that returns from overseas investments would be higher when accounting for exchange rates.
While those investments flattered returns in the three consecutive years until last year when the euro posted annual losses against its major rivals, 2017 has prompted a sharp reversal in those bets.
The currency has risen more than 13 percent against the dollar so far this year.
So investors have rushed to cover their currency exposure as the euro has gained, notably after the French elections in April and again in July.
Even with this, though, investors say a large chunk of foreign debt investments remain unhedged, indicating hedging-related purchases are likely to resurface if the euro renews its climb.
"If the euro starts to rise again, these investors are going to have to come back and start buying euros again and you could see euro/dollar topside continue," said Michael Sneyd, global head of currency strategy at BNP Paribas in London.
The euro traded at $1.1786 on Monday, not far off a 2-1/2 year high of $1.21 tested in early September.
BlackRock strategists recommend hedging currency risk fully for an international bond portfolio but market watchers estimate that only about 60-70 percent of these international debt investments by European investors are currently hedged.
Sneyd estimates that every 1 percent rise in overall hedge ratios translates into roughly $10 billion buying of euros, a sizeable chunk for even the euro/dollar exchange rate which is the most liquid in the world and has an average daily trading volume of nearly $700 billion.
STABLE EURO
Opportunistic demand for euros from bond holders when there is any sign of currency weakness, explains the euro's recent resilience during the conflict between the Spanish region of Catalonia and the central government, as well as unexpected German election results.
The euro has remained stable against the dollar and has gained against some other rivals such as the British pound and the Australian dollar since the start of the month.
That stability has puzzled some investors given that the euro was hurt early this year when the popularity of the anti-euro far-right in France ahead of elections sparked fears about the future of the currency bloc.
"We have seen a raft of dollar positive news and euro negative news but the currency has remained in a tight range, indicating some purchasing activity by either bond holders, reserve managers or some large institutional players," said Borut Miklavcic, managing partner at Lindengrove Capital.
Analysts polled by Reuters expect the euro to trade around current levels in three months, indicating that markets still underprice the extent of which this unhedged stock of bonds could boost the currency.
The euro is being watched closely by the ECB as it debates the future of its 2.3 trillion euro stimulus scheme.
A solid recovery provides a favourable backdrop for the ECB to roll back the scheme and which faces a scarcity of eligible bonds for the scheme. But a further rapid rise in the euro could delay that process.
"A high currency should lead to lower inflation pressures and in an area where inflation has been stable but relatively benign it has led some to believe that the ECB may potentially delay removing its stimulus," said Shaughn Wilkie, bond portfolio manager at Macquarie Investment Management.
But it's not only the ECB that are likely to be concerned about a stronger euro give the vulnerability of unhedged positions.
"We still think this is a Damocles sword dangling over euro investors," said BNP Paribas' Sneyd.
(Reporting by Dhara Ranasinghe and Saikat Chatterjee Editing by Jeremy Gaunt)
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