Euro Buys Time as Bund-Treasury Spread at 2-Year High (Update1)

By Matthew Brown and Paul Dobson
Feb. 7 (Bloomberg) -- The highest yields on German short- term bonds in two years relative to Treasuries are boosting the euro, easing pressure on Chancellor Angela Merkel as Europe’s leaders consider expanding a rescue program to end the region’s debt crisis.
Yields on German two-year notes rose last week to 87 basis points more than Treasuries of similar maturity, the most since January 2009, luring investors to higher returns on euro- denominated assets. Europe’s common currency is up 2.8 percent from an eight-year low reached on Jan. 10 against a basket of nine developed-nation peers, Bloomberg Correlation-Weighted Indexes show.
While a Bloomberg survey last month showed investors predict at least one nation will leave the currency within five years and that Greece and Ireland will default, traders are trimming bets the bloc will splinter. Speculators increased wagers the euro will rise to the highest since October as Merkel said Feb. 4 there was “broad consensus” on reaching an accord to boost competitiveness, including debt-limitation rules.
“Merkel is totally on top of this situation, she understands how much of a benefit the euro has been for Germany,” said Pierre Lequeux, London-based head of currency management at Aviva Investors, which oversees about $370 billion. “The only way they can fend off inflation is by engineering a stronger euro. As we’re going through the first quarter the euro will get stronger.”

Record Yields

The euro weakened 10.4 percent last year, the most since its 1999 start on a correlation-weighted basis, as Ireland and Greece were forced to seek bailouts. Bond yields show investors are speculating Portugal will be next, while Spain struggles to recover from a burst property bubble and trim its 20 percent unemployment rate.
Irish, Portuguese and Spanish yields rose to euro-era highs relative to German bunds in November even after the 440 billion- euro ($598 billion) European Financial Stability Facility, or EFSF, was created to ward off speculators betting on a break-up of the currency union.
The euro rose 0.2 percent to $1.3614 versus the greenback as of 1:29 p.m. in Tokyo, and was up 0.3 percent to 111.95 yen.
The region’s growth has lagged behind the U.S., even as Germany’s economy expanded 3.6 percent last year, the fastest pace since data for a reunified Germany began in 1992. Gross domestic product for the now 17-nation region increased 1.7 percent in 2010, according to the median forecast of 20 economists surveyed by Bloomberg, compared with 2.9 percent for the U.S. Europe will grow 1.6 percent this year, versus 3.1 percent in America, separate surveys show.

March Deadline

The Bloomberg Global Poll of 1,000 investors, analysts and traders conducted Jan. 21-24 showed Bloomberg customers were almost evenly divided on whether the euro will eventually collapse. At the same time, 69 percent of the respondents said they had a favorable view of Merkel. The survey has a margin of error of plus or minus 3.1 percentage points.
European Union leaders meeting in Brussels Feb. 4 set a March 25 deadline to come up with what the German chancellor called a “comprehensive” package to address the crisis. The measures may include stiffer sanctions against budget deficits higher than 3 percent of GDP, lower interest rates on loans and allowing the EFSF to buy debt directly from member states.

‘Failure Cataclysmic’

“These things are costly for the German taxpayer and highly unpopular,” said Ulrich Leuchtmann, head of foreign- exchange strategy in Frankfurt at Commerzbank AG, Germany’s second-biggest lender, behind Deutsche Bank AG. “It will only be politically feasible when everyone sees this is the only way out. The euro crisis will go on and on and this will limit the European Central Bank’s room for maneuver.”
Merkel and French President Nicolas Sarkozy said they have the political will to ensure that can’t happen.
“It is of such importance that we will be there whenever it needs to be defended,” Sarkozy said of the euro in a speech at the World Economic Forum in Davos, Switzerland, on Jan. 27.
“The consequences of a euro failure would be so cataclysmic that we can’t even entertain the idea.”
Sarkozy and Merkel are seeking a summit of euro-region leaders for next month to address economic competitiveness as they stepped up efforts to boost sentiment in their currency.
“The year 2010 was a year of trials for the euro,” Merkel said at a joint briefing with Sarkozy Feb. 4. “Germany and France are firmly committed that 2011 will be the year of new confidence for the euro.”

Reversal of Fortunes

Demand from traders for contracts protecting against a drop in the euro against the dollar has fallen by more than 50 percent since June, indicating investors are less concerned the shared currency will weaken.
The euro-dollar three-month 25-delta risk reversal rate was at minus 1.62 percentage points today, down from the 3.40 percentage-point level seen on June 4 that preceded the euro’s tumble to a four-year low of $1.1877 three days later. The rate measures demand for puts that grant the right to sell the European currency versus calls to buy it.
Some bears are starting to bet that the euro’s rally will gain momentum.
FX Concepts LLC, the world’s biggest currency hedge fund, said on Jan. 27 that the euro may strengthen to the $1.4150, before weakening again. Three weeks earlier, the New York firm’s chairman, John Taylor, said it may fall below parity with the dollar this year.

Inflation Focus

The wider interest-rate gap between Europe and the U.S. led Bank of Tokyo-Mitsubishi UFJ Ltd. to predict on Feb. 1 that the euro may see a “temporary move” above $1.40. The bank said it remains bearish on the currency over a 12-month period.
More stability has allowed European Central Bank President Jean-Claude Trichet to shift his focus from containing the sovereign crisis to fighting inflation, while Federal Reserve Chairman Ben S. Bernanke keeps borrowing costs near zero and pumps $600 billion into the financial system by purchasing Treasuries. Unlike the ECB, whose main goal is keeping prices stable, the Fed is also charged with spurring employment.
“We continue to see evidence of short-term upward pressure on overall inflation, mainly owing to energy and commodity prices,” Trichet said at a press conference in Frankfurt after keeping ECB’s main refinancing rate at a record low 1 percent on Feb. 3.
Inflation in the euro region accelerated to a two-year high of 2.4 percent in January, data from the EU’s statistics office in Luxembourg showed Jan. 31. The annual rate in the U.S. rose to 1.5 percent in December from 1.1 percent a month earlier.

‘Genie Is Out’

German debt yields are higher than equivalent U.S.
securities for all maturities through five years, according to data compiled by Bloomberg. Two-year German yields rose from a record low 0.427 percent on May 20, less than two weeks after the EFSF was created in the wake of the Greek bailout.
“The genie is out of the bottle and the ECB is on the path to hiking,” said Richard Benson, a London-based executive director at Millennium Asset Management, who oversees $14 billion of currency funds. “Interest-rate differentials are the overwhelming driver for currencies. There has been a very substantial repricing in the front end of Europe, a colossal move that supports the currency.”
Hedge funds and other large speculators increased bets that the euro will strengthen against the dollar for a third week, data from the Washington-based Commodity Futures Trading Commission show.
The difference in the number of wagers by hedge funds and other large speculators on an advance in the euro compared with those on a drop -- so-called net longs -- was 39,934 on Feb. 1, compared with 22,901 a week earlier and the most since 40,505 in the period ended Oct. 26.
“The underlying desire of the ECB to get on with normalizing policy is positive for euro-dollar,” said Kit Juckes, London-based head of foreign-exchange research at Societe Generale SA. “The Fed doesn’t want to raise rates unless it has to and the ECB would like to get a window of opportunity to hike. The U.S. wins the contest of who has got the weakest currency.”