Euro to get only limited reprieve from EU deal

 

The euro has won a reprieve with a European Union emergency aid deal but the prospect of draconian fiscal belt tightening in some euro zone countries and a more expansive monetary policy will likely cap further gains.

The $1 trillion (665 billion pound) rescue package announced on Monday, which includes euro zone central banks buying government debt, sparked a relief rally in the euro. The single currency jumped more than 2 percent on the day towards $1.31.

Investors were heartened that the plan should prevent countries including Portugal and Spain from following Greece into a debt crisis, and the announcement stopped panic selling in the euro, which hit a 14-month low of $1.2510 last week.

However, analysts say that even if the plan is successfully implemented, it requires Greece, Portugal and Spain quickly to mend their finances and that this may slow their recoveries.

At the same time, the future course of monetary policy is uncertain.

Debt purchases by euro zone central banks, which began on Monday, will be offset by operations to absorb liquidity, making the buying plan different from quantitative easing. Still, it will be difficult to raise interest rates in this situation.

This will keep prospects bleak for the euro, which has already lost roughly 9 percent against the dollar and the yen so far this year, and analysts say it is only a matter of time before the single European currency revisits the $1.25 level.

"The EU plan takes a major risk off the table ... But, medium- to long-term, we are still very pessimistic about the euro" said Ulrich Leuchtmann, currency strategist at Commerzbank in Frankfurt, adding that the euro's relief rally would be limited to the $1.30-1.33 region.

"The ECB is conducting a policy that is more expansive than the market was expecting and is likely to take this stance for a very long time. This will pressure the euro in the longer term."

Leuchtmann added he expected the ECB to keep rates chained at a record low 1.0 percent until mid-2011.

The breadth and scale of the rescue package has helped curb a wave of euro selling, but it does not resolve the problem of economic and fiscal weakness in parts of the euro zone.

"The key problem for the currency remains the solvency issues, which continue to exist and are not directly tackled by these packages" Barclays Capital said in a note to clients.

BarCap added that fiscal tightening by Spain, Italy and Portugal would weigh on growth in those countries for some time, dragging down wider euro zone growth and doing few favours for the euro, even if moves became less volatile.

Its analysts forecast the euro would trade at $1.20 in three months' time.

MORE WEAKNESS

The stampede out of the euro in past weeks pushed the number of short positions in the single currency -- bets the currency will depreciate - to a record low last week.

While such positioning raises the risk of an upward correction, technical analysts say the euro will face tough resistance around $1.3115, the 76.8 percent Fibonacci retracement of its peak-to-trough move in 2008-2009.

In addition, some analysts said investors were unlikely to pile back into the euro, adding they had seen little fresh buying in the single currency on Monday.

"Even if a package is put in place to stop sovereign and contagion risks, the fact that they have to do it is not going to entice people to actively buy the euro" said Stuart Bennett, currency strategist at Credit Agricole CIB.

The euro's current levels did not warrant alarm, he added, given that it was trading well above a 2 1/2-year low near $1.23 hit in October 2008 after the collapse of Lehman Brothers.

"The market can be negative on the euro, but without the panic. We'll likely see a more orderly decline later in the year" Bennett said, adding he saw a fall under $1.25 later in the year, although a move under $1.20 was unlikely.

As the euro's sell-off picked up steam last week, some market participants contemplated a slide down to $1.1747, the level at which the single currency was launched in 1999.

A weak currency is often seen as helpful for an economy as it lowers the price of exports, pushing up demand from overseas. Germany's exporters' association said last week the euro may hit parity versus the dollar by year-end.