Sharp gains leave euro vulnerable

Wed Jan 16, 2013 9:33am EST

Related Topics

* ECB comments last week add to euro gains

* Weak euro zone data could reignite ECB rate cut talk

* Events in February pose risk to euro, including Italy vote

* Investors seen wary of adopting long euro positions

By Jessica Mortimer

LONDON, Jan 16 (Reuters) - Investor bets the worst of the euro zone crisis is over have propelled the euro to heights where it may be vulnerable to renewed worries about a weak economy or resurfacing political and social tension.

The single currency has risen 11 percent against the dollar since July when European Central Bank President Mario Draghi pledged to do "whatever it takes" to preserve the euro, prompting investors to slash bets on it breaking up.

Euro gains have been broad-based, lifting its trade-weighted index to its highest in 9-1/2 months.

But some analysts said it could be close to peaking.

"For now the euro is still a buy on dips but I suspect its fundamental support is not here to stay," said Valentin Marinov, head of European G10 currency strategy at Citi.

The euro's rise accelerated after Draghi last week dashed expectations of a near-term cut in interest rates. He also said the euro zone economy should gradually recover in 2013.

The currency hit an 11-month high of $1.3404 on Monday and could gain further, potentially towards $1.35, as investors scale back their previous rate cut bets.

Back in July, it traded a shade above $1.20.

The euro's vulnerability was highlighted on Tuesday when euro zone finance ministers chairman Jean-Claude Juncker said the currency was "dangerously high".

And recent data has suggested the market may have been too optimistic in its interpretation of Draghi's comments, with the German economy shrinking 0.5 percent in the final quarter of 2012.

"The biggest risk is that the data will continue to be disappointing and fuel expectations of a potential ECB rate cut before long," Citi's Marinov said, adding this near-term risk could push it back towards $1.30.

"The resilience of the euro zone economy implied by Draghi's comments may not be there when you need it."

Add rising political tensions, social unrest or renewed debt problems in the region's periphery and some analysts say the euro could drop towards $1.25, a level not seen since September.

Investors are not uniformly betting on the euro falling, but options traders report pockets of demand to buy protection against the euro falling to $1.22 or $1.20 in a year's time.

An ECB plan, unveiled in September, to buy indebted states' bonds sharply cut yields on Spanish and Italian bonds and helped lift the euro but analysts say debt problems could resurface.

"Tension could rise if we see weak economic indicators, especially in the core. That would make the recovery of peripheral countries even more difficult," said Antje Praefcke, currency strategist at Commerzbank, who forecast the euro would fall to $1.23 by year-end.

However, the ECB bond-buying backstop means analysts do not expect a drop back below $1.20. Early last year, many who feared euro break-up forecast a drop of that magnitude.

FEBRILE FEBRUARY

Events next month have the potential to curtail the euro's rally, including Italian elections on Feb. 24-25.

Former prime minister Silvio Berlusconi, in an alliance with the devolutionist Northern League, is gaining in the polls and could prevent the formation of a more reform-minded centre-left coalition.

"Italian politics certainly have the capacity to undermine the Italian budget, with potentially negative influences into Spain and the whole EMU project," said Jane Foley, senior currency strategist at Rabobank.

Worries about Spain's debt could also resurface when the European Commission produces an assessment on the fiscal outlook for the Spanish government on Feb. 22, which Citi's Marinov said could highlight the risks Spain may need more funding.

And any signs U.S. politicians are struggling to agree a new debt ceiling will spark concern that growth-sapping spending cuts could be implemented. This could hit growth-linked currencies hard, including the euro.

LIMITED SCOPE FOR GAINS

The announcement of the ECB's bond-buying plan led investors to scale back hefty bets on future euro falls.

But Commodity Futures Trading Commission data shows speculators have already all but erased those short euro positions.

Analysts are concerned that risks ahead will make market players wary of adopting long euro positions -- buying euros in the expectation they will be able to sell at a higher price in the future. Instead, some may re-enter short positions.

Henry Lancaster, senior investment analyst at private bank Coutts, believes the market's more neutral positioning in the euro "signals we've had the honeymoon period".

"There are no significant negative positions in the euro and, in summary of the risks, we think there should be."

He forecasts the euro will fall to $1.25 by the end of 2013 and said he would be looking to sell it above $1.30.

However, the euro could stay strong if the risks facing the euro zone fail to materialise.

Rabobank forecasts the euro at $1.28 in three months, but Foley said it could hold above $1.30 if concerns about debt problems in Spain and Italy did not re-emerge.

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