Bloomberg News

Euro 8% Stronger Than Average as Losses Seen for 2012

December 28, 2011

(Updates rates beginning in the second paragraph.)

Dec. 19 (Bloomberg) -- The euro, after falling to its weakest level against the dollar since January, is poised to depreciate further as traders lose confidence in the ability of European leaders to contain the region’s debt crisis.

Measures in the derivatives market ranging from future volatility implied by option prices to the cost of insuring against a drop in the euro to the record number of bearish bets by hedge funds and other speculators, show traders expect the blueprint unveiled by European leaders this month for a closer fiscal accord will fail to stem the declines.

While the euro at $1.3010 remains about 8 percent above the average since it began trading in 1999, bears say that provides more scope for depreciation as bond yields in Italy and Spain approach levels that prompted bailouts of Greece, Ireland and Portugal. Companies from Spain’s Grupo Gowex to Germany’s GEA Group AG are preparing for some countries to leave the euro and bank failures.

“The euro trading where it is now reflects a global lack of confidence in those dealing with the sovereign debt crisis,” Neil Jones, head of European hedge-fund sales at Mizuho Corporate Bank Ltd. in London, said in a telephone interview on Dec. 14. “It is also a signal of more bad news to come in the euro zone. I am not certain what future euro negatives lie ahead, but I am certain there will be more.”

Ratings Peril

Stress in Europe’s financial system, coupled with slower growth, prompted Standard & Poor’s on Dec. 5 to say Germany and France may be stripped of their AAA credit ratings as it put 15 euro nations on review for possible downgrade. Fitch Ratings lowered its outlook on France to “negative” on Dec. 16 and put Spain and Italy on review for a downgrade, citing Europe’s failure to find a “comprehensive solution” to the debt crisis.

“Things are far from complete,” said London-based Fredrik Nerbrand, global head of asset allocation at HSBC Holdings Plc, Europe’s biggest bank by market value, in a telephone interview on Dec. 13.

“Most of policy makers’ recent debate was with regard to fiscal positions as opposed to the underlying problem, which is a lack of growth,” he said. “It’s kind of like a doctor trying to treat the symptoms rather than the cause.” Nerbrand said he currently has no euro-denominated debt.

The euro depreciated 2.54 percent last week, after trading below $1.30 for the first time since January. It declined to a 10-week low against Japan’s currency, finishing at 101.47 yen, down 2.33 percent from Dec. 9.

Merkel’s Confidence

Even with the losses, the euro is only down 1.27 percent the past 12-months against the dollar. Its average since 1999 is about $1.2049, and has ranged from 82.3 U.S. cents in October 2000 to a high of $1.6038 in July 2008.

The results of the Dec. 9 summit, at which 26 of the 27 European Union members agreed to sign up to or consider tighter deficit limits and sanctions against offenders, would have been “unthinkable” a few months ago and “can’t be overstated,” German Chancellor Angela Merkel said in a Dec. 14 speech in Berlin.

Economists at Barclays Plc say a European recession has already begun. The euro area’s gross domestic product will contract 1.4 percent this quarter, 0.6 percent in the first three months of 2012 and stagnate in the second quarter before resuming growing in the third, Barclays said in a Dec. 8 report.

Rising Yields

The debt of Italy was among the worst performing last week of higher-yielding European government securities last week. Italy’s 10-year bond yield climbed 23 basis points to finish the week at 6.59 percent, down from a surge to over 6.75 percent during the week. Italy’s yields rose last month above the 7 percent threshold that led Greece, Ireland and Portugal to seek bailouts. The 10-year yield climbed to 6.84 percent at 1:42 p.m. New York time.

“With the contagion of the crisis having spread to Italy, the risk of a euro breakup is now viewed as no longer non- trivial,” David Woo, the global head of rates and currencies in New York at Bank of America Merrill Lynch, said in a Dec. 13 interview. The bank sees the euro falling to $1.25 by April.

Most measures of the future for the euro has deteriorated this quarter. The six-month euro-dollar option butterfly, which measures the gap in implied volatility of out-of-the money, or virtually worthless, options and those that would likely produce a profit, was 0.55 percentage point today.

Risk Reversal Rates

That compares with the 0.76 percentage point reached on Sept. 26, the highest since April 2009, and is up from 0.36 in March, when EU leaders agreed on a retooled bailout plan for the region’s most indebted nations. A higher number signals traders expect large moves in the currency and are buying insurance to hedge that risk.

The so-called 25-delta risk reversal rate had a 3.64 percentage point premium for euro puts over calls during the first three trading days of last week, before retreating to end the week at 3.12 percent points and to trade today at 2.99 percentage points. A 4.39 percentage-points premium reached Nov. 17 was the biggest since at least 2005, when Bloomberg began to track the data. Puts grant the right to sell the euro, while calls allow for purchases. An increase in the put premium signals investors are wagering the common currency will slide further.

Implied volatility on three-month options for the euro- dollar pair ended last week at 14.3 percent, about four percentage points above its low this year. The gap, which narrowed by the end of the week to 1.2 percentage points, is viewed by traders as an indicator of how expensive or cheap options are.

‘Hedging Downside’

The increase in volatility and the price of the option butterfly since September is a result of demand from longer-term investors, such as corporations, for contracts to provide insurance against further depreciation of the euro, said Bank of America’s Woo.

Grupo Gowex, a Spanish provider of Wi-Fi wireless services, said it is moving funds to Germany because it expects Spain to exit the euro, according to Jenaro Garcia, founder and chief executive officer of Madrid-based Grupo Gowex. Juerg Oleas, CEO of GEA Group, a machinery maker based in Dusseldorf, said it is limiting amounts held at any one bank.

Three-month implied volatility on euro-dollar options reached 2.6 percentage points above the level of historic volatility, which measures the pace of actual price swings in the underlying currency. The gap, which narrowed by the end of the week to 1.2 percentage points, is viewed by traders as a sign that option prices being expensive amid heightened demand.

Option Hedges

“The high price of option hedges against a slide in the euro shows a quiet resignation to the situation rather than out- and-out panic,” Simon Smollett, a senior options strategist at Credit Agricole Corporate & Investment Bank in London, said in a telephone interview on Dec. 12. “The work the ECB and European politicians are going to do is going to take time; there is no instant solution.”

That’s little comfort for European banks which saw their cost to borrow in dollars in the currency swaps market surge last week. The three-month cross-currency basis swap, the rate banks pay to convert euro-based payments into dollars, fell to 147 basis points below the euro interbank offered rate, signaling an increased price for dollar funding, before easing by the end of the week to 122 basis points below Euribor, and moving to 112 basis points below today.

On Dec. 8, banks received only 109 basis points less than Euribor when using the swaps market.

‘Range of Outcomes’

Hedge funds and other large speculators held a record net 116,457 contracts at the CME Group as of Dec. 13 that the 17- nation currency will fall versus the dollar in the, according to Commodity Futures Trading Commission data. The so-called net- shorts exceeded the previous all-time high of 113,890 in May 2010, when Greece accepted a 110 billion-euro ($145 billion) aid package.

“The possible range of outcomes for Europe is quite binary,” Jose Wynne, the head of North America foreign-exchange research at the investment banking unit of Barclays, said during a briefing at the firm’s New York office Dec. 8. “Either you fix it or trouble comes. If more trouble comes then all of the banking sector in Europe will be feeling the stress.”

--With assistance from Simon Kennedy in London and Joshua Zumbrun in Washington and Manuel Baigorri in Madrid. Editors: Philip Revzin, Dave Liedtka

To contact the reporters on this story: Liz McCormick in New York at emccormick7@bloomberg.net

To contact the editor responsible for this story: Dave Liedtka at dliedtka@bloomberg.net


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