Intervention fears should scare off euro bears

LONDON (Reuters) - The euro’s recent rapid fall has not been sharp enough to trigger official intervention, yet the fear that authorities may step in should be enough to scare off ultra-bears in a historically over stretched market.

An employee checks an Euro note at the Bank of Taiwan head office in Taipei May 10, 2010. Global policymakers unleashed an emergency rescue package worth about $1 trillion to stabilise world financial markets and prevent the Greek debt crisis from destroying the euro currency. REUTERS/Pichi Chuang

The euro fell to four-year lows of $1.2142 last week and has lost more than 13 percent since January.

Many investors doubt the fall has been “disorderly” -- central-bank speak for a disruptive move that would warrant intervention by authorities, who did not intervene even after a global rout following the collapse of Lehman Brothers.

Various long-term fair value analyses show the euro is still overvalued, while an export-friendly decline in the euro helps regional growth at a time of severe economic stress.

However, in a market where speculative bets against the euro are running at all-time highs, the shadow of the European Central Bank could be enough to encourage investors and traders to think twice before targeting a move beyond $1.20.

Indeed, the euro shot up 4 percent between Wednesday and Friday as investors grew worried it may have gone too far.

Intervention by Switzerland, which traders estimate to have bought 17 billion euros ($21.11 billion) on Wednesday to weaken the franc, and talk Australia may intervene to support the local currency, are also making investors nervous.

“The short euro view is such a crowded trade... you can definitely see scope for a decent reversal. People get nervous and that is enough to push it all the way back,” said Phyllis Reed, head of economic, currency and fixed income research at Kleinwort Benson.

“But the euro zone doesn’t mind a weak euro at all. It helps the euro area as a whole. They would really rather have a fair valued currency than an expensive currency.”

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In the past four months, the euro has fallen about 10 percent on the trade-weighted index. This should worry investors who remember the European Central Bank intervened after the euro fell 11 percent in 10 months in 2000.

An analysis by Brown Brothers Harriman shows the euro has declined versus the dollar at an annualized rate of around 63.2 percent since mid-April, which is among the largest falls the euro has recorded since its 1999 birth.

This has the makings of a classic bear trap, an ideal opportunity for authorities to intervene as even small-scale buying would trigger major clearing of stretched positions.

However, the euro’s move so far does not seem to be out of line with fundamentals or long-term values.

An estimate based on the OECD measure of purchasing power parity suggests the euro/dollar is in fact 7 percent overvalued at current levels, based on an implied PPP rate of around $1.17.

A Morgan Stanley model shows the probability of coordinated intervention stands at 30 percent, compared with a long-term average of 12 percent.

At the height of the crisis in December 2008, this model, based on momentum, real exchange rates and positioning, showed a probability of 50 percent -- and still there was no action.

“While the momentum of the euro decline is attracting attention, this is a move toward, and not away from fundamental fair value. This suggests that the threshold for action has not yet been reached,” the bank said in a note.

“In fact, the euro still remains relatively rich compared to its fair value. Against that backdrop, FX intervention to support the euro may not be viewed as credible, and hence, may not provide a durable boost to the single currency.”


Option markets, however, are flashing a warning. Euro/dollar risk reversals -- which reflect investor bias -- hit a 17-month high near 3 percent this month in favor of euro puts.

Three-month volatility hit 1-year highs of 15.5 percent, beyond 12 percent hit after the September 11, 2001 attacks, although below the 23 percent peak of October 2008.

“This high volatility alone is destabilizing. It makes commerce more difficult. It makes cross border movement of capital more difficult,” said Marc Chandler, head of FX strategy at BBH.

Euro zone policymakers not hesitated in taking action to introduce two-way risks and restore order to feverish markets. The ECB has been buying peripheral euro zone debt while Germany has banned naked short selling of some securities.

This suggests there is no reason for traders to believe the FX market is off-limits and investors may get jittery ahead of a Group of 20 finance chiefs’ meeting in South Korea on June 4-5.

Chandler says the key is Washington’s stance.

“If U.S. officials were to conclude that the euro’s decline/dollar rise was a risk to the economic recovery or that it posed systemic risk, rather than being a symptom of such risk, then intervention would seem more likely,” he said.

“Indications from the options market warn that a continued drop in the euro may bring forward precisely those considerations.”