By Matthew Brown
Aug. 10 (Bloomberg) -- The euro’s biggest drop in more than two months against the dollar may signal the best is over this year for Europe’s common currency.
The euro fell 1.1 percent on Aug. 7 as the MSCI World Index of stocks rose 0.4 percent, the second time in a month the currency failed to appreciate as it did earlier this year when equities gained. For BNP Paribas SA, which correctly forecast in May that it would rise to $1.40 from $1.3390, the breakdown means the euro’s strength is ebbing. Goldman Sachs Group Inc., which earned more than $100 million from trading for a record 46 days last quarter, says the euro is going to “stall.”
“Upside potential is limited as euro-dollar has been quite disappointing in recent weeks, given that we’ve had near perfect conditions for a rally,” said Ian Stannard, a currency strategist in London at BNP.
Growing evidence the economy of the 16-member euro region will lag behind the U.S. is turning investors against the currency. The dollar jumped Aug. 7 as the pace of U.S. job losses slowed in July, with the euro ending last week at $1.4183, down from this year’s high of $1.4447 on Aug. 5.
In the two weeks through July 27, the euro strengthened 2.1 percent against the dollar as the MSCI World Index rose 12 percent. That compares with a 12 percent gain when the index added 45 percent between March 9 and June 11.
The euro was little changed today at $1.4198 as of 7:08 a.m. in London.
Correlation Fades
The euro’s 0.48 correlation with the MSCI World Index in recent weeks compares with the Canadian dollar’s 0.71, the Swedish krona’s 0.72 and Australian dollar’s 0.76, Bloomberg data show. A higher number shows markets move closer to lock- step.
The 12 percent gain in the European currency from its 2009 low of $1.2457 on March 4 was fueled in part by rising investor appetite for higher-risk assets, such as stocks, and by central banks moving some of their reserves out of dollars.
For much of the past five months the euro benefited from a renewal of the carry trade, where investors borrow funds in countries with low interest rates such as the U.S. and Japan and invest the proceeds in those with higher returns, allowing them to profit from the difference. The euro was a beneficiary as the European Central Bank kept its main refinancing rate at 1 percent, compared with between zero and 0.25 percent for the Federal Reserve.
German Bunds
German bunds due in 10 years yielded 74 basis points, or 0.74 percentage point, more than similar-maturity Treasuries at the start of the year. Now, 10-year U.S. note yields are 37 basis points higher than bunds. The U.S. premium reached 41 basis points on Aug. 5, the most in two years.
With no yield advantage, traders have little incentive to keep pushing the euro higher with the economy likely to recover more slowly than the U.S. The median forecast of 17 strategists surveyed by Bloomberg is for the region’s economy to shrink 4.3 percent this year and grow 0.5 percent in 2010. That compares with a contraction of 2.5 percent for the U.S. in 2009 and expansion of 2.1 percent next year, a separate poll shows.
“The euro is strong against the dollar because the dollar is weak against everything,” said Thomas Stolper, a global markets economist in London at Goldman Sachs, which lost money through trading on only two days in April, May and June, according to an Aug. 5 regulatory filing. “The euro is going to stall against the dollar.”
Dollar Index
The Dollar Index, which IntercontinentalExchange Inc. uses to track the U.S. currency against the euro, yen, pound, Canadian dollar, Swiss franc and the Swedish krona, dropped 11 percent to 78.975 last week from its high this year of 89.624 on March 4. It gained 1.1 percent since July 29, when New York- based Goldman Sachs recommended dropping bets that the euro will keep rising versus the dollar.
The likelihood that central banks keep diversifying their foreign reserves from the dollar may underpin the euro, Stolper said. At the end of the first quarter the dollar accounted for 65 percent of allocated global central bank reserves, down from 73 percent in 2001, the International Monetary Fund said June 30.
Gains ‘Unavoidable’
The euro’s “rise as the second-most important international currency is almost unavoidable,” Otmar Issing, the former chief economist at the European Central Bank and one of the architects of monetary union, said in a telephone interview from Frankfurt on Aug. 5.
Most strategists say the euro won’t continue to strengthen. The median of 46 estimates compiled by Bloomberg is $1.40 by the end of the year, the same as in mid-June. Frankfurt-based Deutsche Bank AG and UBS AG in Zurich, the two biggest currency traders, predict a decline to $1.30 by January.
Purchasing power parity, a measure of the cost of similar goods in different countries, indicates the euro is overvalued by 28 percent against the dollar, Bloomberg data show. The last time it reached that level, in September 2008, the euro fell 8.4 percent the next month, tumbling to the lowest level in more than two years. The IMF said July 30 it’s as much as 15 percent overvalued.
On a trade-weighted basis, the euro has fallen this year. The Bank of England Calculated Effective Exchange Rate for the euro fell to 102.50 on Aug. 7 from 105.2 on Jan. 1.
Initial Phase
“The initial phase of the risk rally has been indiscriminate, as people bought anything but the dollar and the yen,” said Derek Halpenny, the London-based European head of foreign-exchange strategy at Bank of Tokyo-Mitsubishi UFJ Ltd. “As it becomes more evident that some economies are outperforming others, the markets will become more choosy about which currencies they buy.”
Europe’s economy may prove the euro’s biggest hurdle. Retail sales in Germany, Europe’s largest economy, unexpectedly dropped for a second month in June, slipping 1.8 percent. European producer prices tumbled 6.6 percent, the most in at least 28 years. In the U.S., sales at retailers rose 0.6 percent from May, the biggest gain since January, while the Labor Department’s producer-price index increased 1.8 percent, twice as much as anticipated.
“We have a strong conviction that the euro will eventually have to weaken because the economy is not strong enough,” said Ken Dickson, who oversees currency investments in Edinburgh at Standard Life Investments, which manages $194 billion in assets.
Options Signal
Options show the rally may be over, after bets that the European currency will rise against the dollar reached the most in more than two months on Aug. 4. Contracts to sell the dollar against the euro, or puts, cost 0.7 percentage points more than options to buy, or calls, on Aug. 4., the biggest difference since June 2, according to Bloomberg data.
Bollinger bands, the most-accurate of eight technical indicators for predicting moves on the euro over the last six months, according to Bloomberg data, show that the currency is unlikely to move much higher against the dollar. The upper band was at $1.4447 compared to the euro’s spot price of $1.4183 at the close of trade on Aug. 7.
“The euro has been overbought in the last month and as a fundamental instrument of value it’s the weakest in terms of growth potential,” said Stuart Thomson, an international fixed- income fund manager who helps oversee about $107 billion of assets at Ignis Asset Management in Glasgow, Scotland.
To contact the reporter on this story: Matthew Brown in London at mbrown42@bloomberg.net
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