After showing muted reaction to European bank stress test results, the euro is unlikely to add much to its gains against the dollar as investors focus on euro zone economic weakness. Friday's test results failed to add significant impetus to the euro's rally. While it edged up to an 11-week high versus the US currency of $1.3036 on Tuesday, the single currency will soon head lower as volatility subsides, analysts say.
-- Euro unlikely to add much to its gains vs dollar
-- Weak eurozone fundamentals, fiscal woes to sting euro
-- Euro faces technical resistance at $1.3125
Despite Tuesday's gains, the euro hovers near levels in London on Friday, when test details began to trickle out and showed all but seven of 91 European banks could cope with another recession. Analysts say technical resistance is also capping euro gains.
The euro has rallied more than 6 percent versus the dollar this month, putting it on track for its best monthly showing since May 2009, but much of its strength has been the result of a weaker dollar as the US economic outlook deteriorates.
Many analysts had expected that as long as the stress tests unearthed no nasty surprises, the euro could take a further step upwards once the event risk was over. Some analysts expect the euro to nudge a little higher against the dollar if US economic data shows further weakness, but they add that, as negative dollar sentiment subsides, the euro should retreat later in the year.
"The euro should peak as the market gets more accustomed to the pattern of relatively weak US data and relatively stronger euro zone data," said Ulrich Leuchtmann, currency strategist at Commerzbank in Frankfurt. He added that the euro may rise to $1.31 by the end of September before reversing gains to end 2010 around $1.28.
TECHNICAL RESISTANCE Analysts say dollar selling on concern the US economic recovery has stalled has been overdone as market liquidity dries up during the holiday season. A slowdown in dollar selling will limit the euro's capacity to strengthen, while any signs the euro zone economy is struggling will call into question the health of the region's banks after the stress tests, putting the euro on the back foot.
"Evidence of decelerating economic activity will likely bring back doubts over whether these tests were stressful enough and provide enough credibility to instil permanent confidence," Derek Halpenny, European head of global currency research at BTM UFJ, said in a note. He added that this would prompt more risk aversion, which would push the euro lower, particularly versus the yen.
The euro's technical picture shows significant resistance. Despite poking above the psychologically key $1.30 four times this month, it has been unable to close above that level, and other failed attempts to hit it on an intraday basis have helped fortify that obstacle.
Above that, $1.3125 is a key level to break if the euro is to climb higher, as it is the 38.2 percent Fibonacci retracement of the its peak-to-trough move between November 2009 and June. With the stress test results out of the way, volatility in currency markets should help to prod the euro lower as the risk premium of holding the single currency decreases compared with before the tests. One-month implied euro/dollar vol fell to around 11.5 percent on Tuesday after climbing near 14.0 percent last week before the results, according to Reuters data.
As trading winds down for the holiday season, Simon Smollett, options strategist at Credit Agricole, said one-month vol would pull back to around 9.5 percent if euro/dollar risk reversals come down. One-month risk reversals, a measure of currency sentiment, had jumped in the lead-up to the results to suggest a bias for euro selling, but Smollett expects a pullback now they are over. On Tuesday they were around 1.30 percent in favour of euro puts, inching down from 1.35 percent last week.
"Euro/dollar risk reversal is still a little anxious, but it should come in more," he said, adding that this would result in lower one-month vol, which at the moment was too high given lower equities volatility as measured by the VIX index. Smollett said the slide in euro/dollar vol would help to push the euro lower, and Credit Agricole analysts said a fall to $1.2520 in the coming months was possible.
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