Foreign-exchange traders are putting their faith in Jean-Claude Trichet, betting the European Central Bank (ECB) President will save the euro from a collapse predicted by everyone from George Soros to Paul Volcker.
While the region’s debt crisis now threatens Italy and Spain after infecting Greece, Ireland and Portugal, the euro has appreciated 1.6 per cent this year against a basket of nine developed-nation counterparts, according to data compiled by Bloomberg. Only the Swiss franc has done better. The currency shared by 17 countries gained last week as financial markets were roiled by further evidence that the global economic recovery is weakening.
The strength underscores confidence in Trichet’s ability to prop up the currency until government officials reach a long- term agreement to reduce the region’s expanding budget deficits after Greece, Ireland and Portugal had their credit ratings cut to below investment grade. The ECB’s solution has been to buy government bonds, driving yields lower, and then draining the extra euros pumped into the financial system by the purchases before it can spark inflation.
“A lot of people are scratching their heads and wondering why the euro has been so resilient and it’s because the ECB stepped in the market and took the pressure off the European banking system,” said Paresh Upadhyaya, head of Americas G-10 currency strategy at Bank of America Corp in New York, who estimates the euro will end the year at $1.45.
“That in turn helped support the euro and is why the euro is on the cusp of breaking $1.45 instead of on the cusp of breaking $1.40.”
YEAR-END FORECASTS
The euro strengthened 1.1 per cent last week to $1.4397, and gained two per cent to 1.1303 versus the franc. A Bloomberg Correlation-Weighted Index tracking the euro’s performance rose to 99.9616 last week from 98.2357 at the end of 2010.
It has gained against every major currency except the Swiss franc this year. Strategists have increased their year-end forecast for the euro versus the dollar by 9.2 per cent since January, according to data compiled by Bloomberg.
Trichet and his policy makers have bought government bonds in an effort to contain borrowing costs before a plan by European Union leaders goes into effect. EU leaders last month proposed expanding the role of the ¤440 billion ($632 billion) European Financial Stability Facility (EFSF) — the fund that has helped bail out Greece, Ireland and Portugal — to buy bonds in the secondary markets, aid troubled banks and offer lines of credit. The plan will go into effect after the parliaments of member nations approve it.
ITALIAN, SPANISH YIELDS
ECB data show it bought ¤22 billion of government bonds in the week ended August 12. It purchased an undisclosed amount last week. Besides buying debt, Trichet extended the central bank’s unlimited lending to financial institutions through year-end to ease financial market tensions.
Ten-year yields on Italian and Spanish bonds closed last week at 4.93 per cent and 4.97 per cent, after surging as high as 6.4 per cent and 6.5 per cent in the first week of August.
Unlike the Federal Reserve, the ECB mops up the extra currency it creates through a program known as sterilization. It does that by auctioning seven-day term deposits from banks. The Fed’s $2.35 trillion in bond purchases, known as quantitative easing, went unsterilised, inflating the supply of dollars.
“The euro has held up exceptionally well, unbelievably well,” said Lane Newman, director of foreign exchange at ING Groep NV in New York. “The euro at times has done badly against other currencies but it has held up very well against the dollar because of the fact that now the ECB and the rest of the European finance ministers put a backstop under it.”
MONEY FLOWS
Bank of New York Mellon Corp, the world’s largest custodial bank with more than $26 trillion in assets under administration, has seen more money pouring into the euro by some of its largest customers, said Samarjit Shankar, a managing director for the foreign-exchange group in Boston.
Flows were as much as one and a half times higher last week than the weekly average over the past year, according to Bank of New York’s data, which is used by the International Monetary Fund and the Bank of Japan in their analysis. Euro inflows in the week through August 12 were 95 per cent greater than previous weeks over the past two years, Morgan Stanley reported Aug. 15. The firm’s clients were “very heavy buyers” in the past year, said Calvin Tse, a London-based currency strategist at Morgan Stanley.
DOLLAR WEAKNESS
Rather than a referendum on the euro, the currency’s strength may reflect the dollar’s weakness, according to Camilla Sutton, a Bank of Nova Scotia currency strategist in Toronto. Sutton expects the euro to strengthen to $1.50 this year as lawmakers in the US struggle to reach consensus on spending cuts and a long-term budget plan.
“The expectation is that the US dollar will weaken, based on having a particularly loose monetary policy at the Fed as well as having no credible plan in place nor a political will to get one,” Sutton said.
Standard & Poor’s downgraded the US credit rating for the first time ever August 5, saying lawmakers failed to cut spending enough to reduce record deficits. It kept the rating outlook at “negative” and said further reductions are possible if spending isn’t trimmed as much as agreed to by lawmakers. Moody’s Investors Service and Fitch Ratings affirmed their AAA ranking for the debt of the U.S.
NOT ENOUGH
Steps taken by euro area leaders to stem the region’s sovereign-debt challenges may not be enough to sustain the rally, according to BNY Mellon’s Shankar. German Chancellor Angela Merkel and French President Nicolas Sarkozy have stopped short of supporting euro bonds, which would allow nations to issue debt backed by all members of the region.
“A lot of hard decisions need to be taken and the policy consensus is just not there,” Shankar said. “It’s almost like the ECB is putting together a slew of fire-fighting measures, but you still need a longer-term solution and that’s why the specter of contagion continues to hang over the region.”
For all of the region’s fiscal troubles, the euro is still 14 per cent stronger against the dollar than its average in the past decade, data compiled by Bloomberg show. Governments across the region, from Greece to Spain, have implemented austerity measures to bring down deficits.
TOUGHER ENFORCEMENT
In her August 16 meeting with Sarkozy, Merkel highlighted the need for tougher enforcement of deficit rules, including a numerical annual debt-reduction target for countries with debt over 60 per cent of gross domestic product, the euro zone’s legal limit. Greece’s debt-to-GDP was about 140 per cent at the end of 2010, while Italy’s ratio was about 120 per cent.
Currency analysts say the euro will end the year at $1.43, according to the median estimate of 42 strategists in a Bloomberg News survey. That compares with a year-end forecast of $1.32 for the common currency at the beginning of 2011.
“If we see full follow-through on the commitments that are being made in budgetary policies across the euro zone, that does get us to a position of debt sustainability,” said Ray Attrill, head of currency strategy at BNP Paribas SA in New York. He estimates the euro will rise to $1.55 by year-end.
While Merkel and Sarkozy have voiced opposition for joint bond sales by euro-area nations, EU regulators may push for the so-called euro bonds. Commissioner Olli Rehn said the EU may present draft legislation on euro bonds when completing a report on the feasibility of common debt sales.
SOROS, VOLCKER WARNINGS
The performance of the euro contrasts with sentiment a year ago, when billionaire investor Soros and Volcker, the former chairman of the Fed from 1979 until August 1987, warned that the currency union was in danger of dissolving.
Some nations in the euro may need to take a “sabbatical” while they resolve fiscal issues, Mohamed El-Erian, the chief executive officer of Pacific Investment Management Co, said last week in a Bloomberg Television interview. Newport Beach, California-based Pimco manages the world’s largest bond fund and oversees about $1.34 trillion of assets.
The ECB’s two interest-rate increases this year have also helped boost the euro. The central bank raised its benchmark lending rate from one per cent, where it was during the financial crisis, to 1.5 per cent to contain inflation.
In the US, the Fed has kept its rate at a record low zero to 0.25 per cent and said this month that it will maintain the range at least through mid-2013 to spur the economy. The Bank of Japan and Bank of England haven’t raised their rates since the start of the 2008 financial crisis.
“Monetary policy has been significantly more dovish in the US versus Europe,” said Aroop Chatterjee, a currency strategist at Barclays Plc in New York. He estimates the euro will appreciate through the end of the year to $1.49. While Europe’s debt crisis will take time to be resolved, ECB action will help allay market concern, he said.
