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Euro assets risk losing long-term friends
April 23, 2010 / 4:41 PM / 7 years ago

Euro assets risk losing long-term friends

By Natsuko Waki - Analysis

<p>A sculpture showing the euro currency sign is seen in front of the European Central Bank (ECB) headquarters in Frankfurt April 1, 2010. REUTERS/Kai Pfaffenbach</p>

LONDON (Reuters) - Failure to stem investor concern about Greece’s ability to repay debt risks making outflows from European stocks and the euro disorderly, and would scare away even long-term supporters such as reserve managers.

A request from Greece to trigger a European Union/IMF aid package on Friday brought only a muted response from the region’s asset markets, with the euro and stocks paring gains and five-year Greek debt yields rising.

Investors anxious about Greece’s ability to pay its debt have been steadily pulling money out of the euro zone. Fund tracker EPFR’s data shows Europe equity funds saw outflows for the 11th week in a row in the week ending April 21.

However, asset market moves have so far been orderly. Implied volatility on the German benchmark DAX index and on one-month euro/dollar options -- gauges of market risk -- are near or below the 200-day moving average.

“It’s been a very orderly move, but how would the market behave if there was a default? It won’t be as sanguine a move as we’ve seen already, it would be rather more precipitous... None of that looks good for the euro zone PLC,” said Simon Derrick, head of currency strategy at Bank of New York Mellon.

“Reserve managers are tasked with preserving these reserves. By definition, concerns about what’s happening in Greece must heavily weigh on their minds.”

The euro hit near a one-year low against the dollar on Friday, on track for a fifth consecutive monthly decline.

But currency traders have reported steady euro buying in the past few days from Asian and Middle Eastern central banks -- which hold the majority of the world’s $8 trillion of FX reserves -- helping slow its decline.

Since its launch in 1999, the euro has become the world’s key reserve currency after the dollar, with its share in global reserves standing at 27.4 percent in the final quarter of 2009.

That status may be at risk.

NIGHTMARE SCENARIO

Euro assets have suffered a series of blows in the past week. The premium investors demand for holding Greek debt over German benchmarks hit 12-year highs almost daily, and the cost of insuring Greek debt against default rose to record level.

On Thursday European Union data showed Greece’s 2009 budget deficit was far larger than expected and Moody’s cut Greece’s credit rating, triggering sharp falls in currency, fixed income, equity, and even energy and commodity markets.

The latest turmoil prompted Group of Seven finance chiefs, meeting in Washington, to spend a session discussing Greece. European officials asked their U.S. and Japanese counterparts for verbal support, in a sign policymakers are desperate to show a united front.

Other evidence shows euro zone equity outflows. Fund managers polled by BofA-Merrill Lynch have underweighted the region’s stocks for three months in a row while a UBS study showed investors have been exiting southern European markets after a surge in Greece’s default insurance costs.

“The nightmare scenario is moving closer day by day... Greece is slowly bleeding to death. The market is saying Portugal is next in line and Spain is a much more serious problem,” said David Karsboel, Saxobank’s head of strategy.

“The market is not impressed by this bailout package. If it continues, it’s just a matter of time before Greece defaults. Contagion will be a big problem and if that happens that would be very bad for the euro.”

The fallout could spread beyond the euro zone. Credit Suisse said it might cut its mid-year and year-end targets for the S&P 500 index of 1,220 and 1,270 .SPX respectively if the aid package did not manage to ring-fence Greek worries.

A steady decline in the euro could prompt investors to use it as a vehicle to bet on higher-yielding currencies -- a form of carry trade which could inflict more pain.

“Funding long emerging market positions out of the euro often makes sense since it reduces volatility and correlation to risk sentiment and improves the valuation angle of such trades,” Goldman Sachs said in a note to clients.

“Over the last few months the market has broadened out its funding profile from funding almost purely out of dollars to funding more out of the euro or out of a basket of G3 currencies.”

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