Euro Impaired as Draghi Undoing Trichet Rates Cuts Support
Foreign-exchange strategists are reducing their forecasts for the euro at the fastest pace this year as European Central Bank President Mario Draghi’s interest- rate cuts remove one of the currency’s pillars of support.
Since Nov. 3, when Draghi began to undo the rate increases implemented earlier this year by his predecessor, Jean-Claude Trichet, analysts have cut end-of-2012 estimates for the euro to $1.32 from $1.40, based on the median of 40 forecasts in a Bloomberg survey as of last week. It has weakened versus every major currency except the Swiss franc since then, after gaining against 12 of the 16 this year prior to that.
Investors are fleeing assets denominated in the 17-nation currency as European Union leaders fail to end concern that Italy and Spain will succumb to a sovereign-debt crisis that forced Greece, Ireland and Portugal to seek bailouts. While euro bulls say sentiment is so negative that the currency has nowhere to go but up, bears point to surveys showing the euro zone’s economy will expand 0.5 percent next year, compared with 2.19 percent for the U.S.
“There still has to be further monetary easing by the ECB to support growth in the euro area for 2012 and beyond,” Ken Dickson, investment director of currencies at Standard Life Investments in Edinburgh, which manages about $235 billion, said in a Dec. 9 telephone interview. “There’ll be further weakness, particularly in the first half of next year,” which may push the currency to as low as $1.20 from $1.3386 last week, he said.
For much of this year, relatively high interest rates gave international investors an incentive to hold European fixed- income assets even as the threat of more bailouts rose.
Trichet’s increases in April and July pushed the ECB’s main refinancing rate to 1.5 percent from 1 percent, helping drive yields on two-year German bunds to 1.31 percentage points more than U.S. Treasuries of similar maturity on May 4 from 0.2 percentage point in January. The euro appreciated as much as 16 percent in that period. Since then, the gap has shrunk to 0.09 percentage point, and the euro has depreciated about 10 percent.
The two-year Treasury-German note spread has “been the most statistically significant” driver of the euro-dollar exchange rate “over time,” strategists at New York-based Citigroup Inc. said in a Dec. 9 report to clients.
Europe’s common currency fell 1.1 percent to $1.3242 at 9:48 a.m. New York time. It dropped 0.7 percent to 103.14 yen and weakened 0.7 percent against the pound to 84.82 pence.
European leaders unveiled a blueprint last week for a closer fiscal accord to save the currency, adding 200 billion euros ($265 billion) to their bailout fund and tightening rules to curb future debts. They also will start a 500 billion-euro rescue fund next year and diluted a demand that bondholders shoulder losses in rescues.
The measures failed to spur the ECB, which has bought 207.5 billion euros of sovereign bonds since May 2010 to curb a rise in borrowing costs, to commit to purchasing more securities. Yields on Italian five-year securities jumped as much as 65 basis points, or 0.65 percentage point on the day of the Dec. 8 ECB meeting, rising above 7 percent the next day.
“There’s an element of disappointment in that much more could have been done,” Samarjit Shankar, a managing director for the foreign-exchange group at Bank of New York Mellon Corp. in Boston, said in a Dec. 9 telephone interview. “The tolerance of investors has been severely tested and there’s a general expectation that a lot more needs to be done.”
Cumulative outflows from the euro last week were twice the average in the same period last year, according to BNY Mellon, the world’s largest custodial bank, with more than $26 trillion in assets under administration. The firm doesn’t provide specific figures.
Bets against the euro are at about a record high, suggesting that any positive news may cause traders to unwind those trades, sending the currency higher, according to Pierre Lequeux, head of currency management at Aviva Investors.
“The market is already positioned for a collapse of the euro and therefore there’s not much room for them to add to the existing position,” Lequeux, whose firm manages about $420 billion, said in an interview at his office in London on Dec. 9. The single currency may rebound to as high as $1.50 next year, which would be “driven by a credible solution,” he said.
Hedge funds and other large speculators held a net 95,814 contracts at the Chicago Mercantile Exchange as of Dec. 6 anticipating a drop in the euro, from 104,302 a week earlier, according to the Washington-based Commodity Futures Trading Commission. In May, there were 99,516 contracts wagering on a gain.
The last time there were about as many contracts betting on a decline was in 2010, just before the euro began a rise from $1.1877 in June to as high as $1.4282 that November.
For all the concern that the euro may break up, the currency is about 11 percent above its average since being created in 1999. That’s a sign that traders see little chance of a collapse. The currency will end March at $1.30, the weakest quarter-end level next year, based on median quarterly estimates of strategists surveyed by Bloomberg News.
Last week’s EU summit sets Europe on the path to a “lastingly stable euro,” German Chancellor Angela Merkel told reporters. “The breakthrough to a stability union has been achieved.”
Growth in the euro area’s economy next year will probably slow from a projected 1.6 percent in 2011, while U.S. expansion may accelerate in 2012 from 1.8 percent this year, according to Bloomberg surveys of economists.
Stress in Europe’s financial system, coupled with slower growth, prompted Standard & Poor’s on Dec. 5 to say Germany and France may be stripped of their AAA credit ratings as it put 15 euro nations on review for possible downgrade.
A slumping economy may prompt the Frankfurt-based ECB to cut its main refinancing rate a further 0.25 percentage point to 0.75 percent by March, shrinking the difference between the Federal Reserve’s target rate to 0.50 percentage point, separate surveys show. The gap would be the smallest since 2008.
Bets that the euro will drop against the dollar increased in the options market. Traders paid 3.6 percentage points more on Dec. 9 for the right to sell the euro against the dollar than to buy it, up from about 1.2 percentage points in January. The so-called three-month 25-delta risk reversal rate rose 0.17 percentage point on Dec. 9 after EU leaders agreed at the summit to enforce stricter debt and deficit limits.
Dollar Funding Costs
Dollar funding costs for European banks increased after the summit amid concern the measures won’t be enough to stem the crisis. The three-month cross-currency basis swap, the rate banks pay to convert euro payments into dollars, ended last week at 122 basis points below the euro interbank offered rate, from 117 basis points the day before. The measure reached 163 basis points on Nov. 30.
Looser policy from the ECB “may accentuate the process and continue to force the euro lower in due course,” Geoffrey Yu, a currency strategist at UBS AG in London, said in a telephone interview on Dec. 8. “The market is reaching a consensus that there aren’t going to be many upside factors for the euro at this stage and if Draghi is thinking of further rate cuts, it just adds to pressure on the euro.”