FOREX-Euro climbs, but gains seen limited before ECB

Tue Jul 31, 2012 6:53am EDT

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By Michael Szabo

LONDON, July 31 (Reuters) - The euro rose against the dollar on Tuesday on month-end demand, but stayed below three-week highs on doubts the European Central Bank can meet market expectations of bold steps to combat the debt crisis.

Expectations that the ECB may lower interest rates in coming months saw the euro hit a record low against the higher-yielding Australian dollar. The Aussie was also buoyed by comments from Chinese premier Wen Jiabao that China would fine-tune policy to support economic growth.

The single currency rose 0.25 percent against the dollar to $1.2285, well below the high of $1.2390 hit last Friday. Traders said the euro moved higher due to buying by a sovereign investor in the euro/sterling currency pair, probably to meet month-end requirements.

That led to some to pare bets on euro weakness. Traders cited strong offers to sell the currency above $1.2300 while bids were layered below $1.2250 and stop losses at $1.2220.

Investors are focused on Thursday's ECB policy meeting after bank chief Mario Draghi pledged last week to do whatever was necessary to preserve the euro. That raised expectations of a bold ECB response, a move that could boost the currency.

But investors are increasingly questioning how much the ECB can deliver, given euro zone paymaster Germany is opposed to the central bank buying government bonds in the secondary market and granting a banking licence to the bloc's rescue fund.

"There is a clear danger that expectations might be too high...He's got to put his money where his mouth is, as there is a risk of disappointment around Thursday," said Nick Parsons, head of markets strategy at nabCapital in London.

If the ECB does not signal further measures, the euro could fall back below $1.2130, he said, but a firm response could lift it above last week's peak.

"After that you'd really be looking at $1.2693, the high on the last trading day of June, but we'd really need to see monetary shock and awe to take to us to those sorts of levels," Parsons added.

Such "shock" is unlikely with most traders and analysts sceptical that a resumption of ECB bond-buying by itself would be enough to change the euro's weak overall trend. Expectations of further ECB interest rate cuts would keep sentiment towards the currency negative, analysts said.

Earlier this month, the ECB cut its deposit rate, at which banks park excess funds with the bank, to zero, making the euro a funding currency for investors seeking higher yields.

FX DIVERSIFICATION

Since the rate cut, analysts said a popular trade has been to sell the euro against the higher-yielding Australian dollar. The euro fell to a record low of A$1.1645 on Tuesday.

Analysts said central banks have also increased holdings of higher-yielding currencies and that could be one reason why the Australian dollar has been in demand. The Aussie hit a four-month high against the U.S. dollar at $1.0539.

"We've already seen some serious diversification, and these are longer-term decisions and they are not going to turn around in the short term," said Jesper Bargmann, Asia head of G11 spot FX at RBS, Singapore, referring to a shift in asset allocation by central bank reserve managers out of the euro.

The Swiss National Bank on Tuesday published data on its foreign exchange reserves, showing a second quarter increase in euros as well as in "other" currencies.

"The (data) suggests the central bank had been an active buyer of currencies including the Australian dollar (and) Swedish crown," UBS FX strategist Geoffrey Yu said in a note.

These growth-linked currencies tend to benefit when optimism about the outlook for the global economy picks up.

While the Federal Reserve is likely to hold off from adopting another bond-buying programme at its two-day policy meeting that starts on Tuesday, some players think it might adopt such monetary stimulus in coming months.

The dollar edged up 0.1 percent to 78.18 yen.

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