Euro's Slide Meets Resistance as Analysts Draw Line at $1.30

Traders are starting to believe German Chancellor Angela Merkel when she says Europe’s biggest economy will do whatever it takes to save the region’s currency.

Demand for contracts used to hedge against a decline in the euro is disappearing at the fastest pace since September as speculators slash bets that the currency will fall, a pattern that preceded a 13 percent gain over about two months. Strategists have stopped cutting their estimates for the euro against the dollar, with their fourth-quarter predictions at $1.30 since Jan. 10, according to data compiled by Bloomberg.

Since then, the euro rose 5.6 percent to $1.3591 as of 9:31 a.m. in New York from a four-month low of $1.2867 as Germany joined euro-area finance ministers for the first time in saying it’s contemplating expanding a financial backstop that Economic and Monetary Affairs Commissioner Olli Rehn said will repel the most aggressive speculators. A bigger safety net would free European Central Bank President Jean-Claude Trichet to fight an emerging inflation threat as Germany fuels regional growth.

“Euro-zone policy makers are finally moving ahead of the curve,” said Thomas Stolper, a global markets economist at Goldman Sachs Group Inc. in London. “We are near a breaking point in terms of the pressure. It’s getting more difficult for the skeptics to find a crack in the euro.”

Attractive Yields

For all the focus on Europe’s debt crisis, the region’s economy is showing signs of improvement. The Munich-based Ifo institute said Jan. 21 that its index of German business confidence increased to 110.3 in January from 109.8 in December, the highest since records for a reunified Germany began in 1991. French business sentiment also rose.

The euro and the region’s fiscal crisis will be discussed at the “Bloomberg European Debt Briefing” conference in New York tomorrow.

Traders are buying the currency for returns of as much as three times the equivalent American assets amid signs the region’s debt crisis may not get any worse. German two-year notes yield 68 basis points more than Treasuries, the most since January 2009. As recently as July they were the same. The three- month euro interbank offered rate is 1.03 percent, compared with 0.30 percent for the London interbank offered rate in dollars.

The euro rose 1.7 percent versus the dollar and climbed 1.4 percent against the yen last week. It has strengthened 2 percent this year in a basket of 10 developed-nation currencies including the Australian and Canadian dollars, after tumbling 10 percent in 2010, its worst year since the successor to the deutsche mark and the French franc was introduced in 1999. It appreciated almost 15 percent against the dollar from a four- year low on June 7.

Bonds, Swaps, Stocks

“Markets are clearly buying into the view that the European debt crisis is being resolved with modest pain,” Steven Englander, the head of currency strategy for the group of 10 nations at Citigroup Inc. in New York, wrote in a Jan. 21 research note.

Portuguese 10-year yields fell last week to the lowest this month relative to benchmark German bunds, and demand increased at a Spanish debt auction Jan. 13. The cost to protect European sovereign securities fell the most on record the past two weeks, based on the Markit iTraxx SovX Western Europe Index of credit- default swaps. The Euro Stoxx 50 Index rose to 2,970.56 last week, the highest level since April.

“We support whatever is needed to support the euro, also with respect to the rescue fund,” Merkel told reporters in Berlin on Jan. 12.

‘Comprehensive’ Plan

Merkel was responding to remarks by Rehn, who called for a “comprehensive” plan to contain Europe’s debt crisis. His proposals included an expansion of the European Union’s 440 billion-euro ($599 billion) rescue fund, the European Financial Stability Facility.

The EU has already agreed to bail out Greece and Ireland, and bond investors are concerned Portugal, and possibly Belgium and Spain may be next. Portugal 10-year yields have reached the 7 percent mark that preceded Ireland and Greece’s aid requests.

Bonds yields are still sending danger signals to some of the most-accurate forecasters, who say the rebound won’t last.

Wells Fargo & Co., the best foreign-exchange predictor in the 18 months ended Dec. 31, expects a drop to $1.25 by year- end. John Taylor, chairman of the world’s largest currency hedge-fund firm, FX Concepts LLC, said on Jan. 5 the euro may fall below parity with the dollar this year.

“There’s a very significant risk of restructuring in the not too distant future in one of those peripheral economies, which we think should drive the euro quite a bit lower,” said Shaun Osborne, chief currency strategist at TD Securities in Toronto, who sees a decline to $1.05 by the third quarter.

China’s Support

Finance ministers from Europe’s top-rated countries, Germany, France, Austria, the Netherlands, Finland and Luxembourg, met on Jan. 17 to discuss strengthening the rescue fund. A “comprehensive package” will be assembled by March, Finance Minister Wolfgang Schaeuble said Jan. 13.

China, which has the world’s largest foreign-currency reserves, said this month it plans to buy securities from the region’s most-indebted countries. Japan said on Jan. 11 it will purchase bonds issued by one of Europe’s bailout funds, while Russia, holder of almost $500 billion of reserves, said it may do the same on Jan. 18.

“You have to take the broadening of the safety net as a good development for the euro zone,” said Paul Mackel, director of currency strategy at HSBC Holdings Plc in London. “There’s going to be this realization that what Europe has done has been the right thing, and that’s going to put the spotlight on the dollar in a very negative way.”

Risk-Reversals

Euro-dollar three-month risk reversals, which measure demand for options to sell the single currency relative to those that allow for purchases, declined to 1.325 on Jan. 13 from 2.150 on Jan. 7, the fastest drop since the three days ended Sept. 16, according to data compiled by Bloomberg. The euro rallied from $1.2644 on Sept. 10 to about a 10-month high of $1.4282 on Nov. 4.

Futures traders reversed bets the euro will weaken against the dollar, figures from the Washington-based Commodity Futures Trading Commission show. The difference in the number of wagers by hedge funds and other large speculators on a gain compared with those on a drop, so-called net longs, was 4,109 on Jan. 18, compared with net shorts of 45,182 a week earlier, the biggest increase since June.

“The fast-acting speculative community has probably closed out most of their shorts,” said Goldman Sachs’s Stolper. Further improvement in the euro-region economy “will probably imply quite a bit more euro buying,” he said.

‘Muddle Through’

A Citigroup gauge of data surprises, which measures how often and by how much economic indicators surpass Bloomberg median estimates, was at 73 last week for the euro region and 39 for the U.S.

Europe is ahead of the U.S. in tackling deficits from the global financial crisis and recession. U.S. federal government debt will climb to 99 percent of gross domestic product this year from 93 percent in 2010, while the euro region will total 87 percent, according to International Monetary Fund forecasts.

“As there is more evidence of progress being made in Europe on that front it will heighten the attention on the fact the U.S. has made next to no progress in reigning in their deficit,” said Jane Foley, a senior foreign-exchange strategist at Rabobank International in London. “The euro-zone will muddle through the crisis.”

To contact the reporters on this story: Matthew Brown in London at mbrown42@bloomberg.net; Lucy Meakin in London at lmeakin1@bloomberg.net

To contact the editors responsible for this story: Daniel Tilles at dtilles@bloomberg.net.

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