Euro Bulls Crack as Odds of Return to 2013 Lows Jump: Currencies

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, erases all of its gains in a matter of months.

There is an almost 50 percent probability the euro, which has risen more than 5 percent against the greenback since reaching a 2013 low in April, will give back its increase by mid-2014, according to data compiled by Bloomberg. The odds are the highest in seven weeks and up from 37 percent prior to the ECB lowering its key rate yesterday to a record.

While the euro area economy is seen shrinking 0.3 percent in 2013 based on a survey of more than 50 analysts by Bloomberg, the currency has still managed to appreciate on speculation ECB President Mario Draghi would refrain from further stimulus. That changed yesterday, catching traders who had pushed bullish bets to almost record highs off guard. The euro extended a weekly drop after Standard & Poor’s cutFrance’s credit rating by one step to AA.

“We’ve seen a pretty significant positioning clear-out inEurope,” 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 War’

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 the “currency war” as central banks seek to spark their economies through lower currencies.

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 5.1 percent, still making it the best performer among the group. The euro dropped each calendar year from 2009 to 2012, plunging 20 percent.

Strongest Level

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. It has rallied from an almost five-month low of $1.2746 reached in April, and was at $1.3406 as of 7:18 a.m. in London.

The shared currency extended a drop since Nov. 1 to 0.6 percent after S&P cut France’s credit score. “Lower economic growth is constraining the government’s ability to consolidate public finances,” the ratings company said in a statement today.

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

Most Bullish

Futures traders were the most bullish on the euro since May 2011 for 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 for the period. That compares to an average of 3,780 since the CFTC started tracking data for the euro. 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 risks pushing the 17-nation economy back into recession. The cut in the refinancing rate to 0.25 percent from 0.5 percent was anticipated by just three out of 70 economists in a Bloomberg News survey.

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 telephone interview. That “cements the case for a lower euro in coming days and weeks.”

‘Material Shift’

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.

The euro area’s record-low benchmark rate increases the likelihood of unconventional tools such as a negative deposit rate if prices slow further or the economy slows. 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 based on a Euromoney Institutional Investor Plc survey, 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 has 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 year-end, 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.

‘More Action’

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 byNordea Markets last month. UniCredit SpA said last week that such a gain would shave off 0.8 percentage point of 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 0.75 percent today 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.”

reporter on this story: Joseph Ciolli in New York