Bloomberg News

Euro Bulls Capitulate as Trichet Turnaround Cuts Forecasts

September 19, 2011

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Sept. 19 (Bloomberg) -- The rebound in the euro and European stocks last week may prove short-lived in the face of increasing pessimism over the region’s debt, if money-market and derivative trading are any indication.

While the 17-nation currency strengthened 1 percent against the dollar and the Stoxx Europe 600 Index rose 2.5 percent, U.S. short-term debt funds have reduced lending to European banks and the cost for financial institutions to fund themselves in dollars rose. Goldman Sachs Group Inc. and Morgan Stanley cut forecasts for the euro this month, and bets against the currency rose to the most in more than a year.

French President Nicolas Sarkozy and German Chancellor Angela Merkel said Sept. 14 they’re “convinced” Greece, which saw yields on its two-year note rise above 80 percent last week, will stay in the currency union. Central banks agreed a day later to lend the region’s financial institutions dollars. While those moves bolstered the euro, the region’s economy has weakened, leading traders to bet the European Central Bank will lower interest rates over the next year instead of raising them, removing a key support for the currency.

“The euro weakness is legitimate and justifiable,” Sean Callow, a senior currency strategist at Westpac Banking Corp. in Sydney, Australia’s second-largest lender, said in a telephone interview on Sept. 13. “The stark reality is that Greece is never going to pay its debt in full and that all the various patch-up jobs are not going to solve it.”

Net Shorts

Wagers by hedge funds and other large speculators on a drop in the euro climbed to 54,459 in the week ended Sept. 13, the largest so-called net short position since July 2010 data, and down from net longs of 2,539 on Aug. 23, statistics from the Washington-based Commodity Futures Trading Commission show.

The euro dropped 0.8 percent to $1.3693 at 4:56 p.m. in New York, after sliding to $1.3495 on Sept. 12, the weakest level since Feb. 16. It pared losses against its major counterparts after the Greek Finance Ministry said a conference call with the European Union and International Monetary Fund was “productive and substantive.”

Last week’s gain included a jump of 0.9 percent when the Frankfurt-based ECB said it will coordinate with the Federal Reserve and other central banks to conduct three dollar liquidity operations to ensure banks have enough of the U.S. currency through year-end.

European banks have struggled to get funding for dollar assets after U.S. money-market mutual funds cut short-term lending. The three-month loans will be in addition to the bank’s regular seven-day dollar offerings.

Weakness Resumed

A day later, the euro was falling again, sliding 0.6 percent against the dollar and 0.5 percent versus the yen.

Goldman Sachs lowered its year-end forecast for the euro against the dollar to $1.40 on Sept. 14 from $1.45. The common currency may drop to $1.25 by the end of March, Morgan Stanley analysts led by Hans Redeker, head of foreign-exchange strategy in London, wrote in a note on Sept. 13. Nomura Holdings Inc. cut its year-end prediction to $1.30 from $1.40 citing increasing stress in Europe’s fixed-income markets.

The so-called 25-delta risk reversal rate was at minus 3.53 percent today. A negative rate signals greater demand for euro puts relative to calls. Calls grant the right to purchase a currency, while puts allow for sales.

Credit Default Swaps

The Markit iTraxx SovX Western Europe Index of credit- default swaps tied to 15 governments rose as high as 354.5 basis points on Sept. 12 before ending the week at 323.6. The index has climbed from this year’s low of 157.4 on April 8, signaling a deterioration in the perception of credit quality.

A basis point on a contract protecting 10 million euros of debt from default for five years is equivalent to 1,000 euros a year. Swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements.

“The change in our forecast has to do with the ongoing deterioration of the euro-zone bond markets,” Jens Nordvig, global head of Group of 10 foreign exchange strategy in New York at Nomura, said in a telephone interview Sept. 16.

The rebound in the euro on Sept. 15 “was a bit ironic as these swap lines have been in place for a while,” he said. “It really is not a new policy, just an extension of the maturity they were offering.”

Yields to Rise

In the fourth quarter, the European Financial Stability Facility will take over the role from the ECB of buying debt of nations such as Spain and Portugal, which will likely cause yields to rise as the 440 billion-euro fund has a limited capacity, Nordvig said. Higher yields for the region’s most- indebted nations will raise the risk of owning euros, he said.

Speculating on a weaker euro means betting against the ability of Merkel and Sarkozy to keep the EU together. The two said last week in a joint statement that “it is more than ever indispensable” to “assure the stability of the euro zone.”

“Decisive action” by Europe’s leaders may push the euro toward $1.50 by year-end, Pierre Lequeux, head of currency management in London at Aviva Investors, which manages about $410 billion, said in a telephone interview on Sept. 15.

“I can’t believe that European leaders will be so reckless to let the whole situation go after the time and effort they have invested in making the euro work,” he said. While “there is a valid argument to play it to the downside, there’s a lot of risk you could get caught.”

‘Unpayable’ Debt

While the exit by Greece from the euro wouldn’t lead to a breakup of the European Union or the shared currency, it would expose flaws in Europe’s political system that would undermine investors’ confidence. Mario Blejer, who managed Argentina’s central bank in the aftermath of the world’s biggest sovereign default, said Greece should halt payments on its debt to stop a deterioration of the economy that threatens the EU.

“This debt is unpayable,” Blejer, who was also an adviser to Bank of England Governor Mervyn King from 2003 to 2008, said in an interview last week in Buenos Aires. “Greece should default, and default big. A small default is worse than a big default and also worse than no default.”

Greece’s debt is about 140 percent of its economy, according to data compiled by Bloomberg. That compares with about 59 percent for the U.S. at the end of 2010.

Even as Europe’s sovereign-debt crisis worsened this year, the euro received support from prospects the ECB would raise interest rates to contain inflation. Now, that is looking less likely after ECB President Jean-Claude Trichet said at a press conference in Frankfurt on Sept. 8, after the central bank left its benchmark rate at 1.5 percent, that threats to the euro region have worsened and inflation risks have eased.

Growth, Rates

The economy faces “particularly high uncertainty and intensified downside risks,” Trichet said. Financing conditions have worsened in parts of the euro region and the ECB is prepared to pump more cash into markets, he said.

Growth in the euro region decelerated to 0.2 percent in the second quarter from 0.8 percent in the previous three months as governments cut spending to rein in budget deficits. Services and manufacturing growth slowed in August, with a composite index based on a survey of purchasing managers in both industries dropping to 50.7 from 51.1 in July, Markit Economics said on Sept. 5. A figure above 50 indicates growth.

A Credit Suisse Group AG index of traders’ bets on how much the ECB will change its benchmark rate over the next 12 months, showed expectations for the biggest cut in 2 1/2 years, at 34 basis points, or 0.34 percentage point, following the central bank’s policy meeting on Sept. 8.

Funds Cut Back

The cost for European banks to fund in dollars through the foreign-exchange swaps market rose the day following the coordinated central bank move. The price to convert euro-based payments into dollars, as measured by three-month cross-currency basis swaps, ended last week at 87.125 basis points below the euro interbank offered rate, or Euribor, from 81.91 the day before, according to data compiled by Bloomberg. The measure has expanded from less than 8 basis points in May.

A gauge of banks’ reluctance to lend in euros, the three- month Euribor-OIS spread, the difference between Euribor and overnight indexed swaps, ended last week at 75.25 basis points. While that is down from 84.6 on Sept. 12, the most since March 2009, it’s above the mean of 31.65 since the start of 2010.

The top 10 U.S. prime money-market mutual funds cut their assets invested in securities including commercial paper issued by European banks in July to the lowest level since 2008, according to Fitch Ratings.

“Over the next month or so the bias overall for the euro has to be down,” Callum Henderson, global head of foreign- exchange research in Singapore at Standard Chartered Plc, said in a telephone interview on Sept. 13. “We’ve seen a lot of headlines which were bearish for the euro.”

Rhetorical Gap

Concern the debt crisis will spread to bigger economies escalated when Credit Agricole SA and Societe Generale SA, France’s second- and third-largest banks, had their ratings cut by Moody’s Investors Service on Sept. 14. French lenders top the list of Greek creditors with $56.7 billion in private and public debt, according to a June report by the Basel, Switzerland-based Bank for International Settlements.

Officials have contributed to investor skepticism. Bank of France Governor Christian Noyer said Sept. 12 that French lenders are capable of facing any Greek response to sovereign- debt difficulties and have no liquidity or solvency problems. Two days before Moody’s cut its long-term debt rating by one level, Societe Generale’s Chief Executive Officer Frederic Oudea told reporters on Sept. 12 that French banks “have no capital problem.”

“Policy makers and bank leaders have all come out and said ‘everything is fine,’ but clearly everything is not fine,” Louise Cooper, a market analyst at BGC International in London, said in an interview on Sept. 14. “The gap between the rhetoric and what the markets are saying about the level of the crisis is huge.”

--Editors: Philip Revzin, Daniel Tilles

To contact the reporters on this story: Liz Capo McCormick in New York at emccormick7@bloomberg.net; Lukanyo Mnyanda in Edinburgh at lmnyanda@bloomberg.net; Allison Bennett in New York at abennett23@bloomberg.net

To contact the editors responsible for this story: Daniel Tilles at dtilles@bloomberg.net; Dave Liedtka at dliedtka@bloomberg.net


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