Euro Volatility Signals Weakness as Confidence Falls

Euro bank notes
The euro closed last week at $1.2112, down from $1.4321 at the end of 2009. Photographer: Kostas Tsironis/Bloomberg

The biggest currency fluctuations since the aftermath of the collapse of Lehman Brothers Holdings Inc. are signaling waning confidence in the economic recovery and prospects for a rebound in the euro.

The euro’s 15 percent plunge against the dollar this year sparked a 6 percent loss for bets tied to foreign-exchange price volatility, according to Royal Bank of Scotland Group Plc indexes. That’s the worst performance among four currency strategies tracked by RBS and compares with a 22 percent gain last year, when the global economy rebounded.

Europe’s sovereign-debt crisis, the failure of regional leaders to improve sentiment toward the euro and diverging growth rates around the world means elevated volatility for years, according to UBS AG, the world’s second-biggest currency trader. Less predictable foreign-exchange levels may endanger the recovery by driving up short-term rates, even as a weaker euro stimulates exports, the Zurich-based bank said.

“The sources of concern won’t go away anytime soon,” said Dale Thomas, head of currencies in London at Insight Investment Management Ltd., which oversees about $144 billion. “We’re defensive and still don’t like the euro.” Thomas said he owns the Swiss franc and the Japanese yen.

Goldman Sachs Group Inc. reversed its forecast for the euro last week, saying it will drop to about a seven-year low of $1.15 by year-end as the European debt crisis deepens. The New York-based firm previously predicted $1.35. Royal Bank of Canada said June 7 the euro will depreciate to $1.10 in a year, after earlier forecasting $1.21, on reduced demand for the currency.

Market Volatility

The euro traded today at $1.2229, down from $1.4321 at the end of 2009. Bloomberg Correlation-Weighted Indexes show it depreciated in seven of the past eight weeks.

JPMorgan Chase & Co.’s G7 Volatility Index shows implied volatility for the most-traded currencies, including the dollar and the yen, reached the highest since April 2009 last month. The measure jumped to 16.95, from 10.47 in April, before ending at 13.43 on June 11.

Prices swings increased even after the European Union crafted a $1 trillion aid package last month to support the region’s most indebted nations and the European Central Bank began buying bonds of member states to drive down yields.

Policy makers in Spain and Portugal now face the risk of labor unrest as they adopt austerity measures to show investors they won’t join Greece in requiring a bailout.

‘Far From Over’

“The collapse of the financial system as we know it is real, and the crisis is far from over,” billionaire George Soros, the founder of Soros Fund Management LLC, said on June 10 at a conference in Vienna. “We have just entered Act II of the drama.”

The World Bank in Washington echoed Soros’ concerns, saying some European nations may experience a second economic slowdown if the region fails to manage its debt crisis, threatening countries from Central Asia to Latin America.

“We’re expecting that growth in the second quarter is also likely to be disappointing, quite possibly seeing negative growth in several European countries and a double dip in some of these economies,” Andrew Burns, the World Bank’s manager of global macroeconomics, said at a press briefing.

Volatility has shaken more than currency markets. The Standard & Poor’s 500 Index fell 8.2 percent last month, the most since a 75 percent surge began in March 2009 through the end of April.

‘Next Phase’

“The first round of currency volatility was driven by concerns about euro-zone sovereign risks,” said Olivier Korber, a currency-derivatives strategist at Societe Generale SA in Paris. “The next phase will come from the divergence in global economic policies and central-bank exits.”

While the fiscal crisis will compel the ECB to keep its main interest rate at 1 percent until the second quarter of 2011, the Federal Reserve will raise its key rate in the first three months of the year, according to Bloomberg surveys of economists. Central banks in Australia, Canada, New Zealand and Norway have increased borrowing costs this year to check inflation and prevent asset bubbles.

Risks to the global economic outlook have “risen significantly,” International Monetary Fund Deputy Managing Director Naoyuki Shinohara said in Singapore on June 9. “After nearly two years of global economic and financial upheaval, shockwaves are still being felt, as we have seen with recent developments in Europe and the resulting financial market volatility.”

Implied Volatility

One-month implied volatility for the euro versus the dollar rose to 18.6 percent on May 21, the highest level in 14 months. It also exceeds the 11.4 percent average in the past year. The measure will average closer to 15 percent in the future, said Mansoor Mohi-uddin, the Singapore-based head of currency strategy at UBS.

Fifty-nine percent of 275 U.S. companies in a survey by Wayne, Pennsylvania-based SunGard Data Systems Inc. last month said currency fluctuations had a “material” effect on net income, up from 40 percent in the previous study. Volatility resulted in a gain or loss of at least 5 percent in the 12 months ended March 31, the company said.

“We now live in a much more uncertain world,” Mohi-uddin said. “The epicenter of the crisis keeps shifting, starting out in the U.S. housing market, then it went to the global financial markets and now it’s in Europe.”

Summer Slowdown

Volatility will slow this summer as the economic rebound deepens and the funding needs of Greece and Spain abate, easing concern about contagion from the euro-region’s debt crisis, said Henrik Gullberg, a London-based analyst at Deutsche Bank AG, the world’s biggest currency dealer.

“If you look at the euro, the price action is becoming increasingly stretched and it’s time for consolidation, which normally entails lower volatility,” he said. “Any renewed rise in volatility by the end of the year will be limited by the continuing economic recovery.”

The euro will rebound to $1.30 by year-end as investor concern about sovereign debt shifts to the U.S., he said.

Losses from employing a short-volatility strategy, where investors sell options protecting buyers against currency swings, compare with a more than 7 percent gain this year from a trend-following plan, the RBS indexes show. Using a valuation strategy, where investors buy currencies they speculate have fallen too far, would have returned 4.5 percent.

Carry Trades

Returns from using a carry-trade strategy, where investors sell low-yielding currencies such as the yen to buy higher-yielding counterparts including the Australian dollar, fell 5.7 percent last month, the biggest drop since October 2008, just after Lehman’s collapse, according to the RBS indexes. The yen climbed 5.8 percent against the Aussie and 19 percent versus the euro this year.

Foreign-exchange fluctuations are also leading Asian exporters to seek currency controls. Central banks in South Korea, Taiwan and China are selling their own currencies, limiting investment inflows and delaying rate increases.

“The sources of volatility are clearly still with us,” said Jerome Booth, who helps oversee about $33 billion as the London-based head of research at Ashmore Investment Management Ltd. “Volatility is likely to go up, not down.”

German Exports

The 15 percent slide of the euro against the yuan this year makes European goods more competitive in Asia and reduced the need for appreciation of the Chinese currency against the dollar. ING Groep NV said June 10 China won’t end the yuan’s 23-month peg to the dollar for a year.

German exports jumped 2.6 percent in the first quarter from the last three months of 2009, the Federal Statistics Office in Wiesbaden said on May 21. While exports declined in April, they surged the most in 18 years in March, the statistics bureau reported on June 8 and May 10.

Finance ministers in Europe have indicated they’re in no rush to stem the euro’s slide against the dollar, saying the current level may underpin the recovery. The currency had been “too strong for the economy,” Belgian Finance Minister Didier Reynders said in Luxembourg on June 7. A $1.20 rate “is not so bad for competitiveness.”

The euro averaged $1.3576 in March, down from a 2009 high of $1.5144 on Nov. 25. A dollar-based investor who bought the Euro Stoxx 50 Index, which tracks equities in countries sharing the euro, at the start of the year has lost 11 percent on the shares and 25 percent when accounting for currency losses. The S&P 500 dropped 2.1 percent in the period.

Goldman Sachs cut its three-month and six-month euro targets to $1.15, from $1.35, saying it was “wrong” in assuming European growth would accelerate, while the U.S. slowed, according to a June 9 report.

“European politics remained a major source of uncertainty,” analysts including Thomas Stolper at Goldman Sachs in London wrote. “The likelihood of continued policy mishaps remains very high in the near term and as a result, the euro will likely remain under pressure.”

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