Euro Worst to Come as Greece Hammerlocks ECB on Rates
Derivative traders are signaling that the euro’s slump to a nine-month low will continue even if European Union leaders bail out Greece.
Short-term rates for borrowing in euros in the forwards market are the cheapest relative to loans in dollars since September. The 50 percent collapse in that spread this month signals investors are betting the European Central Bank will keep its target interest rate at a record low, sacrificing euro strength to prevent deficit cutting by debt-laden economies in the region from stymieing growth.
“Investors have already started to think about the next likely phase of the present crisis, and it appears that all they are finding are new reasons to sell the euro,” said David Woo, global head of foreign-exchange strategy at Barclays Plc in London. “Aggressive fiscal tightening by Greece, Spain and Portugal are likely to plunge their economies back into recession. All else being equal, this calls for a looser monetary policy.”
The shift underscores a turnabout in the two most-traded currencies. In the last three quarters of 2009, the euro outperformed the dollar relative to 15 major currencies tracked by Bloomberg, with Deutsche Bank AG’s euro index gaining 1 percent and the IntercontinentalExchange Inc.’s Dollar Index down 9 percent.
Since Nov. 25, the dollar is up 8.3 percent and has outdone all but four major currencies as the euro lost ground against them. The euro traded at $1.3613 as of 7:11 a.m. in New York, unchanged from Feb. 19. The currency is down 5 percent against the U.S. currency this year.
Futures traders are more bearish than ever on the 16-nation currency, and strategists are slashing forecasts at the fastest clip since December 2008, data compiled by Bloomberg show.
Woo cut his 12-month estimate to $1.40 from $1.45 on Feb. 12. Geoffrey Yu, a strategist at UBS AG, the world’s second largest currency trader, says the euro may test $1.30. Gary Shilling of the economic research firm A. Gary Shilling & Co. in Springfield, New Jersey, said it may slide to parity with greenback. The currency has traded above $1 since 2002.
“It’s a one-size-fits-all monetary policy” for “different fiscal statuses in the individual countries,” said Shilling on Feb. 18 in a Bloomberg Television interview. Greece is “obviously the so-called poster boy, but you’ve got the rest of the PIIGS — Ireland, Portugal, Italy, Spain — right behind it. It isn’t so much that we’re doing anything right but that Europe has got serious problems,” he said.
Ahead of Schedule
The euro fell to $1.3444 on Feb. 19, the weakest since May, a day after the Federal Reserve boosted the rate charged to banks for direct loans for the first time in more than three years. The move signaled anew that the Fed is ready to withdraw unprecedented measures employed against the financial crisis amid increased speculation the ECB won’t raise rates this year.
The currency is down 6.1 percent since Jan. 14, when it closed at $1.4499, its fastest decline since early 2009. Of 41 strategists surveyed by Bloomberg, 36 forecast it being weaker than that level at some point this year. Median forecasts predict it will remain below $1.43 through 2012 and beyond. The consensus year-end forecast for 2010 is $1.41.
The euro posted its biggest gain since July on Feb. 16 after Greek Finance Minister George Papaconstantinou said the nation is ahead of schedule on its plan to trim the EU’s biggest budget deficit and won’t need “a bailout.”
Adrian Foster, head of financial markets research for Asia at Rabobank Groep NV in Hong Kong, said the currency would survive a default by Greece because the country accounts for only about 2.5 percent of the area’s gross domestic product.
“If Greece defaults, I don’t see that that has any particular implications for the euro itself,” Foster said on Bloomberg Television Feb. 18. Greek central bank Governor George Provopoulos said he’s confident the government will meet its “very ambitious” deficit-reduction goals and ward off any further credit-rating downgrades.
Rating agencies “want evidence that the plan is implemented on target” and “some time will need to elapse before they can form a better judgment,” Provopoulos, also a European Central Bank council member, said in an interview in Athens on Feb. 19. “I have full confidence” in the government meeting its goals, he said. “They have to succeed. And they will, I’m sure of that.”
Forward contracts used to lock in interest costs show traders expect the three-month euro-denominated London interbank offered rate to be 1.45 percent a year from now, or about 0.17 percentage point higher than the dollar Libor forward rate. At the start of this month, investors were betting the difference would be 0.41 percentage point, giving the euro more of an edge.
Fixed-income investments denominated in currencies from economies with higher rates yield greater returns, making them more valuable. As recently as July, the gap between the forward rates was virtually zero. The euro appreciated 6.2 percent between July 31 and Nov. 25 as that forward rate spread surged from almost nothing to 0.71 percentage point.
Both the spread and the currency then started tumbling, following a slide in Greece’s stocks and bonds that began in October amid concern that its creditworthiness was deteriorating. Standard & Poor’s, Moody’s Investors Service and Fitch Ratings downgraded the country’s credit in December as its deficit approached 13 percent of GDP.
European Union leaders’ Feb. 11 pledge to support Greece’s efforts to control its finances helped fuel the spread’s sharpest three-week drop since July as more investors became convinced that ECB President Jean-Claude Trichet would keep borrowing costs low.
The Fed will raise its benchmark from a range of zero to 0.25 percent to 0.75 percent by the end of the year as the ECB increases its 1 percent rate by a quarter percentage point, narrowing the difference to half a percentage point, median economist forecasts show. The consensus predictions see the difference shrinking to zero by mid-2011.
“It is fairly clear that not only Greece but several other countries in Southern Europe are probably going to be forced to take fairly severe fiscal contracts,” said Ron Leven, currency strategist at Morgan Stanley in New York. “That combined with already weak growth makes it very unlikely that the ECB is going to be in a position to hike rates.”
The region’s economy grew 0.1 percent in the fourth quarter after expanding 0.4 percent in the previous three months, the European Union said in a Feb. 12 report. Federal fund futures last week showed a 52 percent chance the Fed will raise borrowing costs by the end of September after the U.S. economy surged 5.7 percent last quarter.
“You have a big discrepancy between the Fed’s and the ECB’s timetable,” said Stephen Jen, a London-based managing director at BlueGold Capital Management LLP. “This is supportive of the dollar against the euro.”
Futures traders increased bets against the euro to a record this month. Hedge funds and other large speculators had 59,422 more wagers that the euro would decline than bets on a gain. As recently as the first week in December, traders were bullish on the euro, as they had been for the previous 30 weeks.
“The prospect of sizeable fiscal tightening in many Economic and Monetary Union countries will act as a disinflationary force in many of these countries in coming months, pressuring the euro and keeping the ECB on hold until at least the fourth quarter,” said Nick Stamenkovic, a strategist in Edinburgh at brokerage RIA Capital Markets.
The Greek budget crisis is increasing speculation that the euro region will break up. Societe Generale SA strategist Albert Edwards said the country highlights fiscal imbalances that will lead to the currency’s downfall. Harvard University Professor Martin Feldstein said on Bloomberg Radio this month that the monetary union “isn’t working.”
Robert Mundell, the Columbia University economist who won the 1999 Nobel Prize for research that helped lay the foundation for the currency, said in a Feb. 17 television interview that Italy, saddled with the region’s second-largest debt, is the “biggest threat” to the bloc’s growth. Europe’s fourth-biggest economy contracted 0.2 percent in the fourth quarter, and its debt will rise this year to 117 percent of GDP, the EU’s second highest after Greece, according to the European Commission.
“The Europeans would be silly to let this blow up,” said Dominic Konstam, head of interest-rate strategy for Credit Suisse Group AG in New York. “The ECB will have to be relatively dovish and relent a bit on their plan to withdraw liquidity.”