LONDON, Oct 10 (Reuters) - Selling the euro against just about anything has made money since the European Central Bank cut its deposit rate below zero. But now investor appetite for the trade is dwindling, because big swings in exchange rates are making it look far more risky.
Negative rates on cash parked at the European Central Bank, imposed in June, made it cheaper for return-hungry investors to borrow euros to buy higher-yielding but riskier currencies - so-called "carry trades".
The euro dropped sharply against the likes of the Australian and New Zealand dollars and emerging market currencies including the Turkish lira, the South African rand and the Brazilian real.
But carry trades depend crucially on exchange rates staying stable. In recent weeks, long-dormant currency volatility began to stir, and now investors are pulling in their horns.
The euro hit two-year lows against the dollar this month as ECB and U.S. Federal Reserve monetary policies diverged. But the euro is recovering against a host of riskier currencies, and the derivatives market suggests these gains may have further to go.
Analysts say the single currency's rise has little to do with the euro zone's fundamentals, which are gloomy. Instead, it reflects concerns about how riskier currencies and economies that depend on capital inflows to fund external deficits will fare as the Fed prepares to tighten policy some time next year.
And doubts the ECB, which has pledged to do "whatever it takes" to safeguard the euro, will launch large-scale government bond purchases, known as quantitative easing, or QE, have undermined euro's role as a funding currency for carry trades.
"It is a combination of rising volatility and doubts about ECB QE that is seeing euro-funded carry trades take a breather," said Jonathan Webb, the head of FX strategy at U.S. securities firm Jefferies. "Unless you see the ECB expanding its balance sheet, investors will be cautious."
ECB chief Mario Draghi has said he wants to expand the central bank's balance sheet to levels seen in 2012, or by 1 trillion euros.
The flood of euros through balance sheet expansion is akin to the Bank of Japan's $1.4 trillion asset-purchase programme launched in April 2013 and the Fed's QE policy since 2008.
Such an expansion of the balance sheet is expected to drive down the euro's value. ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^ Graphic on G4 central bank balance sheets and currency moves
The ECB is pinning its hopes on a weaker euro to encourage exports, revive the economy and ward off the threat of deflation. Its reduction in the deposit rate to below zero was the first time a major global central bank had moved rates into negative territory.
The ECB cut it further, to -0.20 percent, in September. It has also laid out plans to buy bundled packages of loans, and it has offered banks cheap long-term loans to shore up the economy.
These measures saw the euro hit a 15-month low against the higher-yielding Australian dollar in early September, before rebounding more than 5 percent in the subsequent weeks.
Gains against the New Zealand dollar, another higher-yielding currency, has also been impressive, with the single currency rising 4 percent in the past four weeks.
Amongst emerging-market currencies, investors have sold the euro against the Brazilian real, Turkish lira and the South African rand.
The lira and the rand hit nine-month highs against the euro in early September while the real hit a 14-month high. But since then, the euro has gained 5.5 percent against the real, 3.8 percent against the lira and about 2 percent against the rand.
"Turkey and South Africa have large foreign exchange funding gaps to cover and therefore have a higher dependency on foreign capital flow," analysts at BNP Paribas said in a note.
"At present, (interest) rates are not high enough to maintain inflow in the current, more difficult, environment, so we expect the lira and the rand to accelerate their depreciation against the euro and the dollar."
In the options market, too, investors are showing less bearishness towards the euro against the higher-yielding currencies. The one-month euro/Australian dollar risk reversals , a gauge of demand for options on a currency rising or falling, has flipped this week to a bias for euro calls, or bets the euro will gain.
"The rise in volatility since September has led to some underperformance in carry trades," said Peter Kinsella, a currency strategist at Commerzbank, pointing to declines by high-yielding currencies like the Australian and New Zealand dollars despite the prospects of further easing from the ECB.
"It is the Fed tightening cycle that is having more of an impact. But the ECB has no option but opt for QE and over a period of time, the euro is headed lower." (Reporting by Anirban Nag, graphics by Vincent Flasseur, editing by Larry King)