Euro falls as ECB disappoints, summit eyed

A picture illustration shows euro banknotes outside the European Commission headquarters in Brussels November 28, 2011.

NEW YORK (Reuters) - The euro fell the most against the dollar in almost two weeks on Thursday after the European Central Bank chief threw cold water on hopes of bold actions to contain the euro zone debt crisis.

Investors, however, refrained from selling the single currency more aggressively ahead of a key European Union summit on Friday.

In a press conference following the ECB's decision to cut interest rates by 25 basis points, President Mario Draghi discouraged expectations the bank would massively step up buying of government bonds.

He also said the euro zone's rescue fund should remain the main tool to fight bond market contagion, despite its clear limits, and that it was illegal for the ECB or national central banks to lend money to the IMF to buy euro zone bonds, appearing to veto one firefighting option under active consideration.

"By refusing to act as a backstop to the euro zone sovereign debt market, the ECB may have created the worst of both worlds scenario by essentially lowering the credit quality of the euro without providing any interest rate relief for the member nations, said Boris Schlossberg, director of currency research at GFT in Jersey City.

Yields on Italian and Spanish government bonds jumped after the ECB meeting. French and Belgian government bonds yields also rose but by less than those on Italian and Spanish debt.

Comments from Draghi that the decision to ease was not unanimous and that the bank did not consider cutting rates further, also weighed on the euro. He also said the euro area is facing substantial downside risks.

Traders said the market perceived the easing of collateral requirements for euro zone banks as riskier because the ECB is lowering lending standards.

The euro fell to a session low of $1.3288 on Reuters data, its lowest since November 30. It was last at $1.3343, down 0.5 percent.

The single currency extended losses against the dollar after a senior German source said Germany rejected some measures in draft conclusions for Friday's summit, including giving the European Stability Mechanism (ESM) a banking license and issuing common euro zone debt.

The conclusions seen by Reuters earlier said the permanent ESM rescue fund would get a banking license and run alongside the EFSF, bolstering its ability to tackle the euro zone debt crisis.

"It highlights the lack of unity and there is not much confidence in anything coming from the summit," said Omer Esiner, chief market analyst at Commonwealth Foreign Exchange in Washington.

The dollar was little changed 77.69 yen.

DOWNSIDE RISKS

Many in the market said the summit will fail to provide a fix to the sovereign debt crisis, which could see the euro extend its decline toward the $1.30 level.

"I think the market is setting itself up for a big disappointment, given that the expectation they're going to do something quite big -- change the treaty, what have you -- has been largely priced in," said Fabian Eliasson, vice president of currency sales at Mizuho Corporate Bank in New York.

"If they do that, we may get a fairly brief rally but then we'll slowly come to the realization that everyone is still broke and having trouble paying their bills."

In the options market, the 25 delta one-month risk reversals for euro/dollar traded around -3.10 vols with a bias for euro puts, compared with 2.75 vols on Wednesday, suggesting traders are more bearish on the single currency.

Implied volatilities rose to 14.30 percent, though still below their 50- and 100-day moving averages, suggesting that investors in general have become less pessimistic about the euro zone, with hedges coming down in price from previous highs.

Despite the ECB initiating measures to support bank lending and money market functioning, funding pressures in the euro zone increased.

The benchmark three-month cross-currency basis swap, a gauge of dollar demand corresponding to the relative premium for swapping euro LIBOR for dollar LIBOR, traded at -121.500 basis points, from -115 basis points on Wednesday.

Wider spreads typically reflect elevated demand to borrow U.S. dollars in the currency forward market and often support the greenback's spot value against the euro.

(Reporting By Wanfeng Zhou; Additional reporting by Gertrude Chavez-Dreyfuss, Steven C. Johnson and Nick Olivari; Editing by Andrew Hay)