Euro soars on EU deal; investors remain cautious

NEW YORK Fri Jun 29, 2012 4:18pm EDT

The map of Europe is featured on the face of a one Euro coin seen in this photo illustration taken in Paris, January 31, 2012. REUTERS/Mal Langsdon

The map of Europe is featured on the face of a one Euro coin seen in this photo illustration taken in Paris, January 31, 2012.

Credit: Reuters/Mal Langsdon

NEW YORK (Reuters) - The euro remained on track for its biggest one-day gain against the dollar in eight months on Friday after euro zone leaders agreed on measures to stabilize banks and reduce borrowing costs for Italy and Spain, but the rally looked set to be short-lived.

Euro zone leaders agreed that its rescue funds could be used to stabilize bond markets without forcing countries that comply with EU budget rules to adopt extra austerity measures or economic reforms.

Details of the agreement, which also includes the creation of a single supervisory body for euro area banks, remain unclear. Still, the outcome surprised investors who had positioned for the euro to weaken as expectation for any action during a two-day European Union summit had all but vanished.

"This is another Band-Aid," said Michael Woolfolk, senior currency strategist at BNY Mellon in New York. "There was not anything material that came out of the discussion that would help resolve the crisis."

Woolfolk said he maintained his three-month forecast for euro/dollar at $1.20, adding that the summit "actually reinforces it."

The euro rose as high as $1.2692 on Reuters data, the strongest since June 21, and was last at $1.2646, up 1.7 percent and on track for its biggest daily percentage rise since late October.

Despite Friday's gains, the euro zone common currency was on pace for a loss of 5.2 percent this quarter, the biggest since September.

Spanish and Italian government bond yields fell sharply on the EU deal, while 10-year Irish government bond yields fell to their lowest since before the country agreed to its international bailout.

Against the yen, the euro jumped to a one-week high of 101.39 yen and was last at 101.16, up 2.4 percent. It was the biggest one-day gain since March 2011, using Reuters data.

The euro also rose 0.8 percent versus sterling to 80.79 pence.

Neil Jones, head of hedge fund sales at Mizuho Corporate Bank in London, said the expectation for end-of-month window dressing in the stock market "is forcing the 'risk on' hand".

"The euro (is) responding by moving higher and triggering short-covering," he said.

Net short euro bets rose to 159,880 contracts from net short positions of 141,066 in the prior week, according to data tabulated to Tuesday but released by the Commodity Futures Trading Commission on Friday.

Much of the change was from a drop of 17,516 contracts in long positions, not from the rise of 1,298 contracts in short positions.

The most recent data from Toronto-based OANDA showed investors were 54.59 percent euro short, or betting against the euro versus the dollar, as New York trading drew to a close on Friday.

The dollar rose 0.6 percent to 79.89 yen but was on track for a quarterly loss of 3.5 percent, also the largest since September.

ECB EYED

Analysts said the euro could make further near-term gains, supported by month- and quarter-end flows. But they expect the rally to fade next week as investors worry some steps are just short-term solutions and others will take time to implement.

Ian Stannard, head of European currency strategy at Morgan Stanley in London, said he does not expect it to rise much beyond $1.27. "It will not be too long before the market realizes there is not much new in the agreement, and that anything that is new has a huge amount of conditionality in it."

Traders said the euro could struggle ahead of chart resistance at the $1.2747 June high. Near-term support was at the 21-day moving average, currently at $1.2546, with stop-loss sell orders reported below.

Some analysts pointed to execution risks in the move to empower the European Central Bank with a supervisory role that could prove to be contentious. The market would also soon start to question whether the euro zone's rescue fund has enough resources to recapitalize banks and buy peripheral bonds.

Attention will turn to an ECB meeting next week, with an increasing number of analysts expecting policymakers to opt to cut interest rates from their current 1 percent. <ECB/INT>

The rally in risk appetite buoyed higher-yielding, growth-linked currencies. The Australian dollar rallied to the strongest since early May and last traded at $1.0229, up 1.9 percent. The New Zealand dollar rose 1.6 percent to $0.8003.

(Reporting by Nick Olivari and Wanfeng Zhou; Editing by James Dalgleish)

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