The euro has sizzled in July but will cool down before the summer weather does as markets brace for an extended period of sluggish eurozone growth.
The euro entered the month trading around $1.21, not far removed from June's trough of $1.1876, its lowest since 2006. Investors feared debt crises in several peripheral eurozone countries might actually unravel the European monetary union.
It has since vaulted above $1.30. Traders say real money investors, including central banks, have driven the move, buying euros and higher-yield currencies such as New Zealand's dollar to boost short-term returns.
Oversold euro conditions and some weak U.S. economic data that dashed expectations of higher U.S. interest rates this year helped spark the short squeeze. Last week's stress tests, which gave most eurozone banks a clean bill of health, and smooth Greek and Spanish debt auctions combined to soothe nerves.
Data from the Commodity Futures Trading Commission showed bets against the euro at a record in May, though they have been scaled back since, with speculators only marginally short euros in the week to July 20.
But at some point, fundamentals will reassert their sway on exchange rates. With the European Central Bank expecting the eurozone to grow by no more than 1.3 percent this year and 2.2 percent next, a euro well above $1.30 may be a bit of a stretch.
"A lot of people were short euros and have been knocked out of their positions, and there was a lot of money behind this recent move out of safe havens to pick up yield. But soon the euro will get too high, and Europe can't sustain that," said Sebastien Galy, senior strategist at BNP Paribas in New York.
"We see it rising to $1.3150 — $1.35 is a super-aggressive target — but then we think the fundamental story will come into play, so nobody is that keen on pushing it much higher."
Shaun Osborne, a currency strategist at TD Securities in Toronto, said once the euro broke above $1.24 earlier this month, technical indicators suggested it could rally to the $1.31-$1.32 area.
"But people are not entirely confident the euro can continue to rally," he said. "At best, it appears to be short-covering rather than people going outright long the euro, and medium-term, we think the euro is still going to fall."
But while euro short-covering against the dollar may be fading, Steven Englander, Citigroup's global head of G10 currency strategy, said the euro's spike against the Swiss franc seems to be gaining momentum.
The pair was last near $1.38, up from around $1.3250 in early July, and Englander says a move to $1.40-$1.4250 could cause more pain for franc longs.
"The rate structure has shifted so much in the euro's favor that we are close to entering into that range, so there may be the risk of quick capitulation in long franc positions," he wrote in a note to clients.
Galy said he expects the euro rally to fizzle before that point. "The market's still heavily long Swiss francs, so this is still a short-covering exercise, but we expect it to be over around 1.40 francs," he said.
BNP Paribas expects the euro to end 2010 at $1.08, above an earlier call for parity but still well off its current level of $1.2980. Galy said global investors will start to favor it as a funding currency to finance carry trades, which in this case would involve using cheaply borrowed euros to finance more lucrative trades in higher-yielding currencies and assets.
In recent years, that role has been filled by the yen, with its perennially low interest rates, and the dollar. The latter became an attractive funding currency after the Federal Reserve cut interest rates to near zero to help the U.S. economy rebound from recession.
Galy said the yen will remain a favored funding currency for Japanese-based investors but expects the euro to displace the dollar as a funding currency for others.
"The U.S. has the potential of getting out of some of its economic issues, but Europe will underperform for a long time," he said. "Hedge funds were burned once on short euro positions, but we're still suggesting they sell the topside in euro/dollar as a source of funding."
Citigroup G-10 currency strategist Michael Hart said a euro dip below $1.20 looks unlikely now that markets are no longer afraid that Europe's debt problems will destroy the eurozone.
But he said a further euro rise would require yield differentials to move in its favor, "which is difficult to envisage in the absence of an actual policy rate move."
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