Foreign-exchange strategists are slashing their forecasts forthe euro at the fastest pace this year as European Central BankPresident Mario Draghi's interest-rate cuts remove one of thecurrency's pillars of support.

Since Nov. 3, when Draghi began to undo the rate increasesimplemented earlier this year by his predecessor, Jean-ClaudeTrichet, analysts have reduced end-of-2012 estimates for the euroto $1.32 from $1.40, based on the median of 40 forecasts in aBloomberg survey as of last week. It has weakened versus everymajor currency except the Swiss franc since then, after gainingagainst 12 of the 16 this year prior to that.

Investors are fleeing assets denominated in the 17-nationcurrency as European Union leaders fail to end concern that Italyand Spain will succumb to a sovereign-debt crisis that forcedGreece, Ireland and Portugal to seek bailouts. While euro bulls saysentiment is so negative that the currency has nowhere to go butup, bears point to surveys showing the euro zone's economy willexpand 0.5 percent next year, compared with 2.19 percent for theU.S.

“There still has to be further monetary easing by the ECB tosupport growth in the euro area for 2012 and beyond,” Ken Dickson,investment director of currencies at Standard Life Investments inEdinburgh, which manages about $235 billion, said in a Dec. 9telephone interview. “There'll be further weakness, particularly inthe first half of next year,” which may push the currency to as lowas $1.20 from $1.3386 last week, he said.

For much of this year, relatively high interest rates gaveinternational investors an incentive to hold European fixed-incomeassets even as the threat of more bailouts rose.

Trichet's increases in April and July pushed the ECB's mainrefinancing rate to 1.5 percent from 1 percent, helping driveyields on two-year German bunds to 1.31 percentage points more thanU.S. Treasuries of similar maturity on May 4 from 0.2 percentagepoint in January. The euro appreciated as much as 16 percent inthat period. Since then, the gap has shrunk to 0.09 percentagepoint, and the euro has depreciated about 10 percent.

The two-year Treasury-German note spread has “been the moststatistically significant” driver of the euro-dollar exchange rate“over time,” strategists at New York-based Citigroup Inc. said in aDec. 9 report to clients.

Europe's common currency fell 0.9 percent to $1.3272 at 10:25a.m. London time. It dropped 0.6 percent to 103.25 yen and weakened0.2 percent against the pound to 85.25 pence.

Europe Blueprint

European leaders unveiled a blueprint last week for a closerfiscal accord to save the currency, adding 200 billion euros ($268billion) to their bailout fund and tightening rules to curb futuredebts. They also will start a 500 billion-euro rescue fund nextyear and diluted a demand that bondholders shoulder losses inrescues.

The measures failed to spur the ECB, which has bought 207billion euros of sovereign bonds since May 2010 to curb a rise inborrowing costs, to commit to purchasing more securities. Yields onItalian five-year securities jumped as much as 65 basis points, or0.65 percentage point on the day of the Dec. 8 ECB meeting, risingabove 7 percent the next day.

“There's an element of disappointment in that much more couldhave been done,” Samarjit Shankar, a managing director for theforeign-exchange group at Bank of New York Mellon Corp. in Boston,said in a Dec. 9 telephone interview. “The tolerance of investorshas been severely tested and there's a general expectation that alot more needs to be done.”

Cumulative outflows from the euro last week were twice theaverage in the same period last year, according to BNY Mellon, theworld's largest custodial bank, with more than $26 trillion inassets under administration. The firm doesn't provide specificfigures.

Bets against the euro are at about a record high, suggestingthat any positive news may cause traders to unwind those trades,sending the currency higher, according to Pierre Lequeux, head ofcurrency management at Aviva Investors.

“The market is already positioned for a collapse of the euro andtherefore there's not much room for them to add to the existingposition,” Lequeux, whose firm manages about $420 billion, said inan interview at his office in London on Dec. 9. The single currencymay rebound to as high as $1.50 next year, which would be “drivenby a credible solution,” he said.

Hedge funds and other large speculators held a net 95,814contracts at the Chicago Mercantile Exchange as of Dec. 6anticipating a drop in the euro, from 104,302 a week earlier,according to the Washington-based Commodity Futures TradingCommission. In May, there were 99,516 contracts wagering on again.

Historical Levels

The last time there were about as many contracts betting on adecline was in 2010, just before the euro began a rise from $1.1877in June to as high as $1.4282 that November.

For all the concern that the euro may break up, the currency isabout 11 percent above its average since being created in 1999.That's a sign that traders see little chance of a collapse. Thecurrency will end March at $1.30, the weakest quarter-end levelnext year, based on median quarterly estimates of strategistssurveyed by Bloomberg News.

Last week's EU summit sets Europe on the path to a “lastinglystable euro,” German Chancellor Angela Merkel told reporters. “Thebreakthrough to a stability union has been achieved.”

Growth in the euro area's economy next year will probably slowfrom a projected 1.6 percent in 2011, while U.S. expansion mayaccelerate in 2012 from 1.8 percent this year, according toBloomberg surveys of economists.

Stress in Europe's financial system, coupled with slower growth,prompted Standard & Poor's on Dec. 5 to say Germany and Francemay be stripped of their AAA credit ratings as it put 15 euronations on review for possible downgrade.

A slumping economy may prompt the Frankfurt-based ECB to cut itsmain refinancing rate a further 0.25 percentage point to 0.75percent by March, shrinking the difference between the FederalReserve's target rate to 0.50 percentage point, separate surveysshow. The gap would be the smallest since 2008.

Bets that the euro will drop against the dollar increased in theoptions market. Traders paid 3.6 percentage points more on Dec. 9for the right to sell the euro against the dollar than to buy it,up from about 1.2 percentage points in January. The so-calledthree-month 25-delta risk reversal rate rose 0.17 percentage pointon Dec. 9 after EU leaders agreed at the summit to enforce stricterdebt and deficit limits.

Dollar Funding Costs

Dollar funding costs for European banks increased after thesummit amid concern the measures won't be enough to stem thecrisis. The three-month cross-currency basis swap, the rate bankspay to convert euro payments into dollars, ended last week at 122basis points below the euro interbank offered rate, from 117 basispoints the day before. The measure reached 163 basis points on Nov.30.

Looser policy from the ECB “may accentuate the process andcontinue to force the euro lower in due course,” Geoffrey Yu, acurrency strategist at UBS AG in London, said in a telephoneinterview on Dec. 8. “The market is reaching a consensus that therearen't going to be many upside factors for the euro at this stageand if Draghi is thinking of further rate cuts, it just adds topressure on the euro.”

Bloomberg News

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