Speculators placing bets against the euro are retreating in the face of tough talk from German Chancellor Angela Merkel. Traders are starting to believe her when she says Germany will do whatever it takes to safeguard Europe's common currency. The euro has gained almost 6 percent against the dollar since Jan. 10. Demand for contracts used to hedge against a drop in the euro has rapidly evaporated. "Euro zone policymakers are finally moving ahead of the curve," says Thomas Stolper, chief currency strategist at Goldman Sachs (GS) in London. "It's getting more difficult for the skeptics to find a crack in the euro."
In January, Germany joined euro zone finance ministers for the first time in saying it is contemplating expanding a financial bulwark designed to repel the most aggressive speculators. "We support whatever is needed to support the euro," Merkel told reporters on Jan. 12.
The EU has already agreed to bail out Greece and Ireland. Bond investors fear that Portugal and possibly Belgium and Spain could be next. A group of European finance ministers met on Jan. 17 to discuss expanding the EU's €440 billion ($599 billion) rescue fund, although no agreement was reached. The European Financial Stability Facility (EFSF), which has already come to the aid of Ireland, is empowered to issue bonds and other types of debt. Proceeds from those sales will then be funneled to needy nations as loans. The ultimate goal: to avoid a debt default by one of the members of the euro club, an event that could cause investors to flee the currency.
European efforts to shore up the currency are getting an assist from outside the region. Japan snapped up more than 20 percent of the EFSF's initial five-year bond issue. Chinese Vice-Commerce Minister Gao Hucheng, while on a visit to Madrid in early January, said China will buy Spanish public debt. "You have to take the broadening of the safety net as a good development for the euro zone," says Paul Mackel, director of currency strategy at HSBC Holdings (HBC) in London.
Another reason for the euro rally is that, for all of the focus on Europe's debt crisis, the region's economy has shown signs of improvement. In Germany, the gauge of business confidence published by the Ifo Institute for Economic Research hit an historic high in January. An index of sentiment among French factory managers rose more than expected in December, France's national statistics office reported.
Despite the encouraging indicators, some forecasters say the euro's rebound won't last. John R. Taylor, chairman of FX Concepts, the world's largest currency hedge fund firm, said on Jan. 5 that the euro may fall below parity with the dollar this year. Shaun Osborne, chief currency strategist at TD Securities (TD), predicts a decline to $1.05 by the third quarter.
These euro bears are now in the minority. Futures traders reversed bets that the euro will weaken against the dollar, figures from the Commodity Futures Trading Commission show. The difference in the number of wagers by hedge funds and other large speculators on a gain by the euro compared with those on a drop—so-called net longs—was 4,109 on Jan. 18, compared with net shorts of 45,182 the week before. Says Goldman Sachs's Stolper: "The fast-acting speculative community has probably closed out most of their shorts."
The bottom line: The euro has rallied, powered by German support for the single currency and encouraging economic indicators on the Continent.