Draghi’s Pledge Means More to Euro Than Lower Rates

Mario Draghi’s pledge to safeguard the euro is proving a more powerful elixir for traders than the potential for lower interest rates as the region struggles to exit its second recession in four years.

The 17-nation currency has climbed an average 2.1 percent against the dollar, yen and U.K. pound since the European Central Bank president left the door open to further cuts in the main refinancing rate on April 4. While suppressing borrowing costs usually weakens a currency, options traders reacted by pushing bearish bets on the euro to the least in more than a month as they chose to focus instead on the benefits to the economy of an accommodative monetary policy.

Europe’s common currency has climbed against 14 of its 16 most-traded peers since Draghi said in July that he would do whatever it takes to safeguard the currency union, three weeks after policy makers lowered rates to a record 0.75 percent.

“The stability of the euro against the dollar shows that people trust what the ECB has done so far to resolve the crisis,” James Kwok, the London-based head of currencies at Amundi Asset Management, which oversees $947 billion, said in a phone interview. “People trust what Draghi is doing. As long as that’s the case, then the euro will remain supported.”

Italy, Cyprus

The euro has proved resilient as Italian elections in February left the nation without a government and Cyprus’s raid on bank deposits undermined confidence across Europe. The euro is now above its average for the past year.

After climbing to a six-week high of $1.3138 on April 11, the euro traded at $1.31888 at 12:24 p.m. in New York. It rose 2 percent to 128.72 yen and gained 0.7 percent to 85.88 pence.

Europe’s shared currency will remain in a range of $1.25 to $1.35 this year, Kwok predicted. The median estimate in a Bloomberg News survey of 57 forecasters shows it ending the year at $1.28, up from an estimate of $1.27 at the end of 2012.

The currency averaged $1.2341 and 97.81 yen in the month before Draghi’s July 26 speech in London, when he said the ECB “is ready to do whatever it takes to preserve the euro.” Against the pound, it averaged 79.21 pence that month, 7.6 percent weaker than today’s price.

Underperforming Economy

Investors are taking on the risk that Draghi’s pledge will leave the region with an overvalued currency that weighs on the recovery and hampers efforts to restore competitiveness.

The $13 trillion euro-area economy will underperform the U.S. by an average of 1.1 percentage points in the three years through 2015, according to Bloomberg surveys of economists. The region shrank 0.6 percent in the three months through December, declining for a fifth consecutive quarter, the same length of time it shrank in its last recession ending June 2009.

“The fundamentals of the European economy still require further easing in monetary policy,” said Ken Dickson, an Edinburgh-based director at Standard Life Investments Ltd., which manages about $264 billion. “In time, we would expect the euro to weaken to reflect that easier monetary path. The recent moves have been surprisingly resilient given that sentiment and tone has been more negative for the euro area.”

Standard Life, Scotland’s second-biggest money manager, is “underweight” the euro in its long-term portfolios, and the currency should be about 10 percent to 15 percent weaker than current levels, Dickson said.

Option Premiums

The ECB’s promise of support, combined with the Bank of Japan’s unprecedented monetary stimulus this month that includes bond purchases, shored up confidence in the euro area and encouraged options traders to scale back risk premiums, according to New York-based Alvise Marino, a foreign-exchange strategist at Credit Suisse Group AG.

The premium for six-month options granting the right to sell the euro against the dollar relative to those allowing for purchases narrowed to 1.3 percentage points on April 9, the lowest since Feb. 21. That’s down from a high for the year of 1.77 percentage points on Feb. 27, according to the so-called 25-delta option risk reversal rate.

The premium on euro puts, which grant the right to sell the 17-nation currency versus the greenback, averaged 2.3 percentage points since 2011.

ECB ‘Deterrent’

Draghi followed up his July comments by outlining a plan known as Outright Monetary Transactions in September. The program allows the ECB to buy short-maturity notes issued by euro-area nations that request aid, though no country has yet activated the plan.

For the bears, the ECB’s backstop “has been a deterrent, even as it hasn’t been accessed,” Marino said in an April 10 phone interview. “The Bank of Japan’s actions have made a big difference, with flows going out of Japan and into Europe, as well as a broad rise in risk appetite.”

Draghi’s pledge is helping lure foreign demand for government bonds, supporting the euro. Asian investors bought 29 percent of the 8 billion euros ($10.5 billion) of five-year notes sold by Europe’s rescue fund on April 9, according to a person with knowledge of the issue, who asked not to be identified because the deal wasn’t public.

Borrowing costs for the region’s most indebted nations are sliding as central-bank liquidity pushes investors to higher-yielding assets. Spanish 10-year bond yields dropped last week to the lowest since November 2010 while the rate on similar-maturity Irish debt sank to a six-year low.

Receding Threat

“The promise of OMT is still working,” Ulrich Leuchtmann, head of currency strategy at Commerzbank, Germany’s second largest bank, said in a phone interview on April 8. “It’s something that makes the crisis coming back in a way that it did in 2011 and 2012 quite unlikely, because we no longer have this threat of spiraling bond yields.”

Implied volatility, used in option pricing models and a gauge of traders’ expectations of future currency swings, fell to 8.35 percent yesterday on three-month contracts, from 8.85 percent at the beginning of the month and 14.7 percent at the start of 2012.

Implied volatility on euro options that hedge exchange-rate risks over the next year is 0.6 percentage point greater than three-month insurance, as the risk of euro swings persisting over the longer term ease. In July, the gap between long- and short-term implied volatility, the so-called volatility curve, reached 2 percentage points, the most since the euro was introduced in 1999.

Relative Value

Even after declining 1.2 percent since the beginning of the year through yesterday, the euro was still 5.5 percent too strong against the dollar, according to an index developed by the Organization for Economic Cooperation and Development in Paris that uses relative costs of goods and services.

It was overvalued by 1.3 percent versus the pound and should have been trading 0.2 percent lower to the yen, the OECD gauge shows.

Richard Benson, an executive director at Millennium Global Investments Ltd. in London, attributes the euro’s continued strength to the region’s healthy trade balance, as well as to U.S. monetary policy.

The Federal Reserve expanded its balance sheet by more than $2.3 trillion since 2008 and is stepping up purchases of Treasury and mortgage debt to spur growth. The euro region’s current-account surplus, the broadest measure of trade because it includes investments, reached 14.9 billion euros in the six months through December, the most on a rolling-average basis since the currency union began in 1999.

“We’ve been surprised by the resilience of the euro around $1.30,” said Benson, whose firm oversees about $15 billion of currency funds.

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