Euro to stay strong vs dollar as policies diverge

The contrast between the Federal Reserve's expected extension of monetary stimulus and the European Central Bank's pledge to remove crisis support will ensure the euro stays strong against the dollar.

The ECB's determination to remove ultra-loose policies stands out against expectations of a new bout of Fed monetary easing this week, the possibility of more stimulus in the UK and Japan's policy of intervening if the yen strengthens too much.

The euro will also benefit from a "currency war," in which many countries are intervening to keep their currencies weak to protect exports.

Many Asian central banks favor the euro as a currency into which to recycle their dollar intervention proceeds.

Analysts see this leading to more near-term euro strength, leaving the odds in favor of a move toward $1.45 or beyond.

Downward corrections are expected to be temporary and capped above $1.35, with concerns about the parlous fiscal and economic situation in some countries on the euro zone's periphery unlikely to haunt the euro until 2011.

"The euro is one of few major currencies where there are no deliberate measures to try to weaken the currency, either directly through intervention or indirectly through QE (quantitative easing)," said Micheal Derks, currency strategist at FXPro.

Analysts say relative euro zone and U.S. interest rate differentials will remain the driver of the euro in coming months, overshadowing peripheral worries and the potentially harmful impact on the euro zone economy of a higher euro.

"The only way we will get a significant turnaround in euro/dollar is if rate spreads converge back again and as far as the eye can see that is not going to happen," said Steve Barrow, head of G10 currency research at Standard Bank.

Barrow predicts the euro will rise to $1.45 in three months, even if the Federal Reserve opts for a relatively small dose of quantitative easing.

Strong Technical Momentum

The euro rose around 12 percent in a seven-week period to mid-October, when it hit an 8-1/2 month high of $1.4161. It then stalled and struggled to establish a foothold back above $1.40, sparking talk of a possible steep correction, particularly with speculators' bets against the dollar at extreme levels.

Technically, however, the euro looks healthy, having closed the last week of October above its 200-week moving average, a signal it may be set for more gains.

Nicole Elliott, technical analyst at Mizuho, said the euro could be in a bullish "flag formation," where a sharp rally higher is followed by limited consolidation, indicating investors are not rushing to get out of their positions.

If this formation is confirmed, Elliott calculates the euro could be set to rise to around $1.54, though it would face strong resistance between $1.45 and $1.50. She sees pullbacks capped above $1.3560, the 38.2 percent retracement of the euro's upward move from late August to mid-October, or, failing that, the 50 percent retracement at around $1.3375.

Some analysts echo this forecast for only mild pullbacks, arguing any correction would be seen by reserve managers and other investors as providing better levels to buy the euro.

"The Fed may do less QE than expected, but there would be opportunities to put the dollar short trade back on because this is a global issue that is more dominant than anything coming out of Europe at the moment," said Maurice Pomery, managing director at consultants Strategic Alpha.

Euro Zone Focus for 2011

Worries about severe euro zone debt problems in countries on the periphery of the euro zone -- which pushed the euro below $1.20 in June -- have not troubled the single currency recently and are not expected to until next year.

RBC currency strategist Adam Cole said peripheral euro zone problems would need to spread beyond smaller countries such as Greece, Portugal and Ireland to a larger country such as Spain before they started to drive the euro lower once more.

"Spain's refinancing requirements don't really step up until 2011 ... so euro/dollar short term will be mostly about the dollar until we get to the point where we're focusing on Spanish auctions and refi requirements."

A second trigger for renewed euro weakness could come if the euro rises toward $1.50, damaging peripheral euro zone countries so much that it prompts the ECB to reverse its policy of gradually exiting its loose monetary policy.

"If the ECB starts to inject liquidity rather than withdraw it that will weigh down on euro/dollar and negate the factors which are at the moment driving dollar weakness. But that is a story for Q4/Q1," said Michael Hewson, analyst at CMC Markets.

[Source: By Jessica Mortimer, Reuters, London, 02Nov10]

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