EURO SWAPS CORNER TRICHET AS CURRENCY SLIDE PERSISTS / BLOOMBERG ( HIGHLY RECOMMENDED READING )

Euro Swaps Corner Trichet as Currency Slide Persists (Update2)

by Liz Capo McCormick

May 17 (Bloomberg) -- Traders are paying the highest price in more than seven years to insure against the euro weakening, betting European plans to fix the region’s debt crisis will worsen the currency’s slide.

Demand for one-month options giving investors the right to sell the 16-nation currency rose last week to the most since before 2003 relative to those that allow for purchases. The premium traders pay to swap one-year euro loans for those in dollars was the widest this month since February 2009.

The increasing price for protection against further declines shows the European Union’s $1 trillion in loan funds to keep members from default has, so far, failed to persuade investors that nations will get deficits under control. At the same time, traders say the European Central Bank and President Jean-Claude Trichet have lost credibility by shifting policies on government bond purchases that are part of the plan.

“The road ahead is still shaky for the euro,” said Stephen Gallo, head of market analysis at Schneider Foreign Exchange in London, which serves clients who trade more than $3 billion a year. “The stress within the European banking system is elevated. ECB credibility has been hurt.”

UBS AG says the euro may depreciate to below $1.15. BNP Paribas SA sees parity with the dollar by March, saying the currency’s outlook “remains bleak.”

The shared currency fell to $1.2235 today, the lowest level since April 18, 2006, after weakening 3.1 percent last week. The euro was 0.4 percent lower at $1.2304 as of 10:56 a.m. in London. It dropped to as low as 112.46 yen, the least since May 6, following a 2.1 percent decline last week.

Volcker’s View

While the euro became a rival to the dollar after its inception in 1999, the debt contagion that began in Greece is driving investors away. Former Federal Reserve Chairman Paul Volcker said May 13 in London that he’s concerned the euro area may break up after the rescue package failed to stem the currency’s decline.

“You have the great problem of a potential disintegration of the euro,” Volcker, 82, said in a speech. “The essential element of discipline in economic policy and in fiscal policy that was hoped for” with the creation of the euro has “so far not been rewarded in some countries,” he said.

Bloomberg Correlation-Weighted Currency indexes show the euro has lost 9 percent this year after falling 7.7 percent in 2009. It has depreciated against all of the 16-most traded currencies since December, according to data compiled by Bloomberg.

‘Euro Is Doomed’

While a weaker euro makes European exports more competitive, it may damp the appeal of the region’s financial assets. A foreign investor in German bunds would have lost 9 percent this year after exchanging euros for dollars, Bank of America Merrill Lynch indexes show.

“The euro is doomed,” said Andrew Wilkinson, senior market analyst at Interactive Brokers Group LLC in Greenwich, Connecticut. “The strains among the partners are becoming clear and it’s becoming harder to see global growth not being threatened by this.”

Foreign bank borrowing of dollars from their U.S. offices increased almost 50 percent to $353.3 billion in the three months ended May 5, according to Fed data tracked by Nomura Holdings Inc. The jump is the largest quarterly percentage rise since 2007.

Lack of Appetite

Derivatives also show a lack of appetite for euros. The currency’s one-month options risk-reversal rate fell to minus 3.2 percent on May 12, from minus 1.25 percent in December, signaling a relative increase in demand for puts, which grant traders the right to sell the euro versus the dollar. It was minus 2.46 percent at the end of last week.

The rate on one-year cross-currency basis swaps between euros and dollars reached minus 58.75 basis points this month, the largest effective premium for dollar borrowing in swaps since February 2009. Basis swaps allow investors to borrow in one currency and simultaneously lend in another.

“Dollar funding got relatively expensive in October 2008 as everyone was looking for dollars, so even though we aren’t yet at those extremes, the basis swaps bear watching,” said Brian Kim, a currency strategist at UBS in Stamford, Connecticut. “They could move sharply and exacerbate any dollar-related moves with regard to the euro as a result.”

UBS cut its 2010 euro forecast last week from $1.30, and lowered its 2011 estimate to $1.10 from $1.25. The median of 39 estimates in a Bloomberg survey is for the euro to trade at $1.25 by Dec. 31. Two months ago, they predicted $1.38.

Relative Deficits

“The cost of securing the future of the euro is proving to be extremely high, as can be seen by the size of the package, and there are a lot of long-term negative implications attached,” Ian Stannard, a senior currency strategist at BNP Paribas in London, said May 10. While the rescue package “may provide some very near-term support for the euro” it “doesn’t have an impact on the longer-term outlook,” he said.

Europe’s debt challenges are no greater than any other major economy, and may be less severe, according to Axel Merk, the president and chief investment officer of Merk Investments LLC in Palo Alto, California. The firm manages the Merk Hard Currency Funds, which gained 6.01 percent the past 12 months, beating 94 percent of its peers, according to data compiled by Bloomberg.

The U.S. will post the third-largest budget deficit among advanced economies this year at 11 percent of gross domestic product, behind the U.K.’s 11.4 percent and Ireland’s 12.2 percent, the International Monetary Fund said May 14. Japan’s debt may rise to 250 percent of GDP by 2015, the IMF said.

Boosting Sales

“The issues we see in the euro zone are not euro-zone specific problems, as most countries in the world have spent too much money,” said Merk, who expects the euro to gain. “The U.K., U.S. and Japan might be in a worse situation than the euro zone is. We continue to believe it is more difficult to spend and print money in the euro zone than in other countries.”

Some European companies may welcome a weaker currency as it boosts the value of their sales abroad.

Hellenic Petroleum SA, Greece’s biggest refiner, said in February that part of its fourth-quarter loss of 37 million euros came from the currency’s strength against the dollar. Novara, Italy-based Autogrill SpA, the largest manager of airport restaurants, said a month later that profitability in its Spanish operations in the same period was “hit particularly hard” by the financial crisis and the euro’s strength against the pound.

The euro weakened 2.2 percent versus the dollar in the fourth quarter and fell 3.3 percent against the pound.

Shifting Policies

The ECB’s shifting policies are weighing on the euro. Trichet said May 6 that bond purchases hadn’t been discussed when the bank’s 22-member Governing Council decided to keep its main interest rate at a record low of 1 percent. Four days later, the ECB said it would start buying debt securities “to address severe tensions in certain market segments.”

Purchasing government bonds means the ECB would effectively be printing cash. Policy makers say they will counter the effects on money supply by draining reserves equal to the amount bought, so-called sterilization.

The dollar fell 10.2 percent last year as measured by Bloomberg Correlation-Weighted Currency Indices when Fed Chairman Ben S. Bernanke started a debt-buying program to support the U.S. economy.

‘Head Through Parity’

The euro “can easily head through parity” with the U.S. dollar under a “hard landing” recovery scenario from the European deficit crisis, according to Royal Bank of Scotland Group Plc. The currency may depreciate to $1.14 by mid-2011, Alan Ruskin, head of foreign-exchange strategy at RBS Securities in Stamford, Connecticut, wrote in a May 13 report.

Bond purchases risk stoking inflation, making it more difficult for the ECB to stick to its mandate of keeping consumer prices in check while at a time of keeping interest rates low to boost the economy.

“Once the recovery becomes entrenched, if the ECB is still buying bonds, investors will become worried about inflation,” said Marco Annunziata, the chief economist at UniCredit SpA in London. “At that point, the ECB, which used to be very proud of its independence, now looks like it has been overwritten by political constraints and will be in a more difficult position to counter inflation expectations.”

Futures Bets

The Fed reinstated its emergency currency-swap program last week, providing as many dollars as needed to central banks to complement the EU bailout plan.

“Funding frictions are not going to go away quickly this time as market participants realize that the broader system is still fragile and in need of central bank support again,” said George Goncalves, the New York-based head of interest-rate strategy at Nomura.

Futures traders increased bets this month to a record that the currency will fall against the dollar. The number of wagers by hedge funds and other large speculators on a decline in the euro rose on May 11 to 113,890 contracts more than those anticipating a gain, according to data from the Washington-based Commodity Futures Trading Commission.

“There are so many headwinds, so many structural issues affecting the euro,” Manoj Ladwa, a senior trader at ETX Capital in London, said on Bloomberg Radio May 11. “It calls into question whether the euro can last. What is the point of having a euro if not only other European countries are bailing out the likes of Greece but also the International Monetary Fund? There’s not much reason to have the euro around anymore.”

Last Updated: May 17, 2010 06:06 EDT