In 2011, Whither Skeptics of Euro?

In 2011, Whither Skeptics of Euro?

Betting on a Common-Currency Tumble Has Been a Loser, as Dollar Proves Even Weaker; Still a Tempting Target

By TOM LAURICELLA

For the second time in a year, European leaders are scrambling to prop up Greece. But the euro is faring far better this time.

Last spring, as Greece first teetered on the brink, there were rising expectations that the common currency would by now have plunged against the U.S. dollar, with some forecasters looking for declines approaching 20%. Talk that the crisis would lead to a breakup of the euro zone added to the gloom.

.From May to June 2010, analysts on average cut their midyear 2011 euro forecasts to $1.1950 from $1.2920, according to Consensus Economics.

Investors, especially hedge funds, flocked to bearish bets on the euro. But, aside from those with very short time horizons, wagering that the European debt crisis would cripple the euro has been a losing bet.

Even as the risk of a Greek default remains, the euro, which was at $1.4267 early Monday in Asia from $1.4302 late Friday in New York, is up nearly 20% from its low under $1.20 in June 2010. The crux of the mistake: not recognizing that the fundamentals behind the dollar would be even worse than for the euro.

"They didn't quite get it right," says Che-wing Pang, editor of Consensus Economics, which collects euro predictions from 69 forecasters. By contrast, euro forecasts for midyear 2012 have been locked around $1.40 for the past two months and are actually up from April.

Analysts caution that the euro could still be vulnerable to collapse against the dollar should there be a disorderly default by Greece on its debt obligations, such as the country unilaterally deciding not to pay bondholders or aid being withheld by the European Union or the International Monetary Fund. Even an organized debt restructuring is seen as potentially sending the euro lower, depending on its impact on European banks.

"There are some scenarios that could still be very bearish for the euro, and the past week has been a wake-up call," says Elsa Lignos, a currency strategist at RBC Capital Markets in London. Even though the markets are expecting Greece to default, "nobody really knows what that means, and its impact depends on what the context is."

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Reuters

Euro notes
.European finance ministers, meeting in Luxembourg to discuss ways to deal with the Greek financial crisis, early Monday morning said they had narrowed their differences over how to get Greece's private-sector creditors to contribute to the country's financing in coming years. But they left crucial details unresolved, most importantly how to get creditors to participate without causing a Greek sovereign default. They will meet again later Monday.

Europe's huge problems continue to make it a tempting target for "short" positions that would profit as the currency falls. Last week saw stepped up buying of options that would give big payouts should the euro drop steeply, such as to $1.10 or $1.15. And as the euro fell toward $1.40 last week, there was renewed talk of a bigger break lower toward $1.35. However, as has often been the case, the euro frustrated the bears and reversed course. "A lot of people have been burned," says Alan Ruskin, a currency strategist at Deutsche Bank.

For example, the managers tracked by the Parker Global Strategies Currency Managers Index have been consistently short the euro over the past year, says Jon Stein, managing director at Parker. However, on balance, "we're looking at very few months where it was a clearly profitable position," Mr. Stein says. The exceptions were November and May, when the euro swooned. Mr. Stein says managers appear to continue to be positioned for a lower euro, but with a bias toward making this bet against currencies other than the dollar.

Meanwhile, many also failed to spot the currency against which the euro would in fact tumble: the Swiss franc. Last week the euro fell to a record low against the Swiss franc and finished the week down 13% from a year ago. One of the driving factors is that, for European investors, the Swiss franc has been seen as a haven thanks to the country's strong fiscal position. The drop against the Swiss franc "is a purer gauge of what the euro would be looking like against something that's perceived as a hard currency," says Deutsche Bank's Mr. Ruskin. "That's very different from the way in which the U.S. dollar is perceived."

Rather than being considered a refuge, the dollar has increasingly been seen as a troubled currency, thanks in part to the poor U.S. fiscal outlook.

But many factors went into the wrong calls on the euro against the dollar. For starters, analysts underestimated the degree to which the European Central Bank would support the bond markets and banks of Greece, Portugal and Ireland. The rest of Europe's economy, meanwhile, proved much more resilient than expected, in large part thanks to strong export growth out of Germany and other so-called core euro-zone countries. At the same time, Spain, whose large economy many worried would tip the euro zone into free fall, has taken steps to shore up its finances.

Meanwhile, the U.S. economy has turned out to be much weaker than expected, last year flirting with a double-dip recession. This time last year, expectations were that the Federal Reserve would likely raise rates long before the ECB. Instead, the Fed launched an unprecedented second round of quantitative easing, pumping money into the financial system through large purchases of bonds and pledging to keep interest rates low for an extended period. Then, earlier this year, the ECB raised rates, and it is expected to tighten again this summer.

The euro has also picked up support from China, which, as officials there did last week, repeatedly pledged to continue buying euro-zone debt. Moreover, in addition to China, managers of other countries' foreign reserves were adding to euro holdings as part of a gradual diversification away from the dollar, analysts said.

The result was that, for all of the euro zone's problems, the dollar was in worse shape. "It was a race to the bottom," says Deutsche Bank's Mr. Ruskin. While working at a different bank last May, Mr. Ruskin predicted the euro would fall to $1.1650 by the end of 2010; instead it finished at $1.33. "So far, the dollar has been winning that race," he says.

Sebastien Galy, a currency strategist at Société Générale, this time last year—while also at a different bank—was arguing the euro needed to fall to parity with the dollar in order to make peripheral economies like Greece more competitive.

Mr. Galy recently joked that he had been told by a student in a class he teaches that the parity call had been a contrarian signal to buy euros. "We made one fundamental mistake in judgment, which was basically Fed policy," Mr. Galy says.

Write to Tom Lauricella at tom.lauricella@wsj.com