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Euro Bulls Crack as Odds of Return to 2013 Lows Jump

Euro Coins
At its peak on Oct. 29, the euro was up 7.2 percent this year against a basket of nine developed-market peers, according to Bloomberg Correlation Weighted Indexes. Photographer: Simon Dawson/Bloomberg

The surprise decision by the European Central Bank to cut interest rates means there’s now about an even chance that the euro, this year’s best-performing major currency, will erase all of its gains in a matter of months.

There’s an almost 50 percent probability that the euro, which has risen more than 5 percent from an April low versus the dollar, will give back its advance by mid-2014, data compiled by Bloomberg show. The odds are the highest in seven weeks and up from 37 percent prior to the ECB lowering rates to a record.

While the euro-area economy is seen shrinking 0.3 percent this year in a Bloomberg survey, the currency still managed to appreciate on speculation ECB President Mario Draghi would refrain from further stimulus. That changed yesterday, catching off guard traders who had pushed bullish bets close to record highs. Standard & Poor’s heaped more pressure onto the euro when it cut France’s credit rating by one step to AA.

“We’ve seen a pretty significant positioning clear-out in Europe,” Brian Daingerfield, a Stamford, Connecticut-based currency strategist at Royal Bank of Scotland Group Plc’s RBS Securities unit, said yesterday in a phone interview. “Euro positioning had gotten fairly bullish.”

Currency Wars

The ECB’s move has global implications, marking the central bank’s first overt step in an effort to nudge the euro lower as a way to combat disinflation and help exporters, Daragh Maher, a currency strategist at HSBC Holdings Plc in London, said yesterday in e-mailed comments. Such moves are referred to as currency wars as central banks seek to spark their economies through lower exchange rates.

European companies have in recent weeks bemoaned the strong euro. German airline Deutsche Lufthansa AG last month cited the currency’s rise when its profit estimate fell short of analyst forecasts, while luxury-goods maker LVMH Moet Hennessy Louis Vuitton SA said Oct. 16 that gains versus the dollar and yen shaved 6 percent off third-quarter revenue.

At its peak on Oct. 29, the euro was up 7.2 percent this year against a basket of nine developed-market peers, according to Bloomberg Correlation-Weighted Indexes. That increase has since been trimmed to 5.4 percent, still making it the best performer in the group. The euro dropped each calendar year from 2009 to 2012, plunging 20 percent.

‘Uncomfortable’ Levels

Over the last few weeks, the market saw the euro “reach levels that many people thought the ECB would be uncomfortable with,” Jane Foley, a senior currency strategist at Rabobank International in London, said in an interview yesterday on Bloomberg Radio. “It seems that, if they are really worried about importing some inflation, this is the way to do it.”

The euro climbed to $1.3832 on Oct. 25, the strongest level since November 2011, after reaching an almost five-month low of $1.2746 in April.

The common currency tumbled as much as 1.6 percent after the cut in the ECB’s refinancing rate to 0.25 percent from 0.5 percent yesterday, which was anticipated by just three out of 70 economists in a Bloomberg News survey. The euro fell 0.5 to $1.3363 as of 12:24 p.m. in New York, poised for its biggest two-week decline in more than a year.

S&P cut France’s credit rating from AA+ today, saying in a statement that “lower economic growth is constraining the government’s ability to consolidate public finances.”

Most Bullish

There was a 45 percent chance yesterday that the euro would fall to its April 4 year-to-date low of $1.2746 by the end of the second quarter of 2014, the highest probability since Sept. 17, according to data compiled by Bloomberg. There was a 37 percent chance of the same move on Nov. 6.

Futures traders were the most bullish on the euro since May 2011 in the week ended Oct. 25, 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 in the shared currency compared with those on a decline, or net longs, totaled 72,434. That compares with an average of 3,780 since the CFTC started tracking the data. The measure reached an all-time time high of 120,000 in May 2007.

With inflation at the weakest level in four years and less than half the ECB’s target, Draghi is seeking to avoid a negative price spiral that would risk pushing the 17-nation economy back into recession.

Inflation Cools

Draghi is “ringing the alarm bell for deflation,” Richard Franulovich, the chief currency strategist for the northern hemisphere at Westpac Banking Corp. in New York, said yesterday in a phone interview. That “cements the case for a lower euro in coming days and weeks.”

Euro-area inflation cooled to 0.7 percent in October, the lowest since November 2009, from 1.1 percent in September, the European Union’s statistics office said on Oct. 31. The median forecast in a Bloomberg News survey of 42 economists was for the rate to stay at 1.1 percent. The data marked the ninth-straight month that the rate has been less than the ECB’s 2 percent ceiling.

A record-low benchmark interest rate increases the likelihood of unconventional tools such as a negative deposit rate if price gains slow further or the economy seizes up. The ECB left the deposit rate at zero yesterday.

The real possibility of negative rates “means the euro will now struggle, as this is a material shift,” Geoffrey Yu, a senior foreign-exchange strategist at UBS AG in London, said yesterday in an interview.

Henrik Gullberg, a London-based currency strategist at Deutsche Bank AG, the biggest global foreign-exchange trader, said yesterday that the ECB doesn’t seem willing to make further cuts for the next couple of months.

Balance Sheet

The euro may still gain as the balance-sheet assets of the ECB and Federal Reserve continue to diverge.

Since the beginning of May, commercial banks in Europe have paid back the equivalent of $130 billion borrowed under the ECB’s Longer-Term Refinancing Operations Program, data compiled by Bloomberg show. That helped shrink the ECB’s assets to 2.3 trillion euros ($3.1 trillion), while the Fed’s have increased to a record $3.9 trillion. The more-than $700 billion gap is the widest since member states established the ECB in 1998.

“The relative balance-sheet movement supports a stronger euro-dollar,” said Daingerfield of RBS, which forecasts that the euro will rise to $1.39 by year-end. “Our view is that euro-dollar will grind higher going into year-end.”

Goldman Sachs Group Inc. sees the euro at $1.40 by Dec. 31, citing a recovery in the trading bloc and capital inflows. The euro-area economy returned to growth in the second quarter, rising 0.3 percent from the same period the prior year.

Economic Growth

An appreciation of 10 percent in trade-weighted terms in the euro has the same effect as an interest-rate increase of 0.5 percentage point to 1 percentage point, according to calculations last month by Nordea Markets. UniCredit SpA said last week that such a gain would shave 0.8 percentage point off gross domestic product over two years, with most of the impact in the first 12 months.

Options traders are becoming more bearish on the euro, widening the premium on contracts to sell the shared currency versus the dollar compared with those allowing for purchases. The three-month 25-delta risk-reversal rate was at minus 0.80 percent compared with minus 0.38 percent two weeks ago, data compiled by Bloomberg show.

“It’s clear that the currency market was caught off guard,” Ian Gordon, a New York-based foreign-exchange strategist at Bank of America Corp., said yesterday in a phone interview. “It fits into our view that the inflation and growth profile was going to push the ECB into more action.”

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