Euro Weakens as Investors Sell to Buy Higher-Yield Assets

The euro fell to a two-year low versus the dollar and weakened against all of its 16 most-traded peers as traders used the shared currency to fund purchases of higher-yielding assets.

The 17-nation currency dropped to the weakest on record versus Australia’s dollar five days after the European Central Bank cut its key interest rate to an all-time low. The yen gained versus most major counterparts as risk appetite eased on concern Europe’s debt crisis remains unresolved. Sterling climbed to the highest level against the shared currency in more than three years.

“Ultimately, it’s a market that’s quite comfortable being short euro,” Jack Spitz, managing director of foreign exchange at National Bank of Canada in Toronto, said in a telephone interview. “In the absence of any fresh positive news, it will likely remain that way.” A short position is a wager a currency will decline in value.

The euro depreciated as much as 0.6 percent to $1.2235, the lowest since July 2010, before trading at $1.2250 at 5 p.m. New York time, down 0.5 percent. The common currency lost 0.7 percent to 97.30 yen and touched 97.23 yen, the weakest since June 5. The yen gained 0.2 percent to 79.43 per dollar.

Australia’s dollar rose 0.4 percent to A$1.2020 per euro and touched A$1.1988. The Aussie fell 0.2 percent to $1.0192 and weakened 0.3 percent to 80.95 yen.

Funding Currency

“The euro is now the main funding currency, and everyone wants to be short euro,” said Sebastian Galy, a senior foreign-exchange strategist at Societe Generale SA in New York. “The dollar is no longer the main funding currency.”

Investors sell currencies of nations with low borrowing costs to purchase those with higher yields in the carry trade. Japan’s yen and the U.S. dollar are traditional funding currencies because the nation’s central banks are holding interest rates at almost zero. The Reserve Bank of Australia’s cash rate target is 3.5 percent, while the ECB cut its rate on July 5 to 0.75 percent.

Implied volatility on three-month options for Group-of-Seven currencies touched 9.37 percent today, approaching a two-month intraday low, according to the JPMorgan G7 Volatility Index. The average over the past year is 11.5 percent. Lower volatility makes investments in currencies of nations with higher benchmark rates more attractive because the risk in such trades is that market moves will erase profits.

Court Challenge

The yen rose extended its advance versus most major peers amid concern a court challenge in Germany may snarl European Union efforts to curb their region’s debt turmoil.

German Finance Minister Wolfgang Schaeuble said he’s confident the European Stability Mechanism and Europe’s fiscal pact are in accord with the nation’s constitution. He spoke after a hearing at the German Federal Constitutional Court in Karlsruhe in a challenge that kept the permanent rescue fund from going into operation today. Opponents said “parliaments are being disempowered” by German loans to weaker economies. No date is set for a ruling.

“There is still a good deal of uncertainty about the ability of policy makers to implement the plans we saw at the end of the last EU summit,” Omer Esiner, chief market analyst in Washington at the currency brokerage Commonwealth Foreign Exchange Inc., said in a telephone interview. “Some of those fears have increased as a result of this legal hearing in Germany regarding the expanded roles of the ESM. That highlights the implementation risk of some of these programs.”

The pound gained as much as 0.5 percent to 78.93 pence per euro, the strongest level since November 2008. Sterling fell earlier against most major peers after Bank of England Governor Mervyn King said the U.K. economy doesn’t show “great signs” of recovering from recession.

Spanish Banks

The euro slid even as European officials laid the groundwork for possible purchases of Italy’s bonds and fast-tracked aid for Spain’s banks. Finance ministers at a meeting in Brussels worked out a way for the euro bailout funds to intervene in bond markets and said the first 30 billion euros ($37 billion) of 100 billion euros in rescue loans will start flowing to Spanish banks this month.

While the loans to Spain will go via the government’s bank-restructuring agency, the aim is to convert them into direct injections once the setup of a single European bank supervisor makes that feasible, Luxembourg Prime Minister Jean-Claude Juncker said. Political hurdles abound to switching to direct aid, which would give European authorities control over the banks instead of saddling the Spanish government with the debts.

“The fact that the bank recapitalizations may be delayed for a couple of months could be a source of weakness in the euro,” Charles St-Arnaud, a foreign-exchange strategist at Nomura Holdings Inc. in New York, said in a telephone interview.

Extra Year

The finance ministers gave Spanish Prime Minister Mariano Rajoy’s government an extra year, until 2014, to drive his nation’s budget deficit below the euro limit of 3 percent of gross domestic product.

Sweden’s krona reached its strongest level against the euro since 2000 after industrial production fell less than forecast. The currency climbed against all of its most-traded counterparts tracked by Bloomberg. It gained as much as 1.1 percent against the euro to 8.4348, the strongest level since December 2000, before trading at 8.5551, up 0.8 percent. It rose 0.3 percent versus the dollar to 6.9834.

Swedish industrial production fell an annual 2.3 percent in May, Stockholm-based Statistics Sweden said in a statement today. That compared with a decrease of 6.9 percent estimated in a Bloomberg survey and a 6.4 percent drop a month earlier.

The euro weakened 2.4 percent over the past month, the worst performer with the Swiss franc among the 10 developed-nation currencies tracked by Bloomberg Correlation-Weighted Indexes. The New Zealand and Aussie dollars were the biggest winners, both rising 3.3 percent. The greenback declined 0.4 percent and the yen slipped 0.4 percent.

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