REFILE--FOREX-Euro edges higher as liquidity tightens, yen gains

Wed Dec 11, 2013 8:08am EST

* Euro edges back towards 6-week high vs dollar

* Higher money market rates lend support

* Yen gains on profit-taking after euro, dollar rallies

By Laurence Fletcher

LONDON, Dec 11 (Reuters) - The euro inched higher against the dollar on Wednesday, driven by dwindling excess cash in the euro zone banking system, but fell against the yen as investors locked in profits from this year's rally.

The euro was up 0.1 percent against the dollar at $1.3767, not far from the six-week high of $1.3795 it hit on Tuesday. It was 0.2 percent down against the yen at 141.15 yen but up 23 percent this year.

The single currency has shrugged off some poor recent economic data - particularly in France, where industrial output is declining - to surprise many analysts and move higher since the summer.

A key driver has been tighter money markets, as banks repay borrowing from the European Central Bank. Liquidity usually tightens towards the end of the year anyway, when banks hold off from lending to each other.

And the ECB's unwillingness to ease monetary policy soon, despite inflation low enough to prompted talk of deflation, has seen a rise in two-year swap rates.

This year, another factor driving euro strength is European banks repatriating funds to shore up their capital bases before an ECB Asset Quality Review (AQR).

"There still seems to be decent underlying euro support," said Simon Smith, head of research at FxPro. "We're still seeing money market rates moving higher."

He said the euro could hold "around the upper 1.30s level" early next year. It might weaken fall after the AQR, but Smith expects it to fall less against the dollar than other currencies decline when the U.S. Federal Reserve begins slowing its huge bond-buying programme.

One-year risk reversals - which compare demand for options on a currency's rising or falling - show a bias for euro puts, or bets that it will weaken. That suggests many speculators think the rally will not last.

The euro also took heart from news that euro zone countries were edging towards a deal on how to handle ailing banks. Divisions remain over key parts of the reform, which is needed to underpin confidence in the bloc's lenders.

The Swiss franc hit a seven-month high against the euro of 1.22055 francs per euro in early trading, before falling back to 1.22150 francs per euro, as banks repatriated francs.

The yen rose for a second day as global stock markets fell and investors locked in profits. The dollar was 0.3 percent lower against the yen at 102.55 yen.

Global shares were lower on Wednesday, as investors booked profits on a range of once-crowded positions. The Nikkei and the yen tend to move in opposite directions, with a rally in the index a signal for speculators to sell the yen. A weaker currency then boosts Japanese exports, which helps shares.

Both the euro and the dollar have rallied strongly against the yen this year thanks to the Bank of Japan's ultra-loose monetary policy and expectations that it will provide even more stimulus next year.

"It's a bit of profit-taking from high levels," said Peter Kinsella, a currency strategist at Commerzbank.

Analysts at Morgan Stanley said they remain bullish on dollar/yen over the longer-term but added: "We ... note that the current uptrend is showing some signs of exhaustion, suggesting that it would not take too big a shock to trigger a correction of the strong gains seen over the past year."

The dollar showed little reaction to news that budget negotiators in the U.S. Congress have reached a two-year deal aimed at avoiding a government shutdown.

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