NEW YORK (Reuters) - The oft-maligned euro has become 2013's currency darling, and its recent run may not be over.
Signs that the euro zone economy is recovering has reawakened interest in the single currency. While other major central banks are ballooning their balance sheet, European banks are paying back loans from the European Central Bank. For the first time in three years, activity in the options market indicates that investors expect gains in the euro in coming months, instead of losses.
"It is no longer taboo to be positive on the euro," said Axel Merk, chief investment officer at Merk Funds in Palo Alto, California.
The euro's rally this year has lifted it to a 14-month high against the dollar, a 34-month peak versus the yen and 15-month high against the pound.
Merk, who oversees $640 million, said he has been "very long" the euro since August 2012, when ECB President Mario Draghi promised to do whatever it takes to save the euro. Merk said it could reach near $1.50, the 2011 high.
He said he has bought forward contracts as well as high quality short-term euro denominated debt, typically from northern European countries, in the spot market.
Easing fears about a breakup of the euro zone and an improving German economy have added to the euro's momentum. Even though political uncertainty in Spain and Italy this week revived some worries, the euro held above $1.35, which had been a barrier for months.
The options market last week showed a historic shift in euro sentiment. For the first time in three years investors placed bets on further near-term euro gains, with euro/dollar one-month risk reversals, a measure of the relative demand for options betting on the euro rising or falling, switching in favour of euro calls - a bet on a rising euro.
As the euro zone crisis has receded as a concern, the "central bank balance sheet race" will become a more important driver than the risk-on/off theme, said David Gilmore, a partner at Foreign Exchange Analytics in Essex, Connecticut.
Banks in Europe have begun early repayment of long-term loans from the central bank. As a result, the ECB's balance sheet has shrunk to the lowest since February 2012, even as the U.S. Federal Reserve, Bank of Japan and Bank of England continue to expand their balance sheet.
"The ECB is mopping up liquidity while the Fed, BoJ and BoE are printing money, so the long-term trend of euro appreciation is unstoppable," Merk said.
NEAR-TERM GAINS EXPECTED
Forecasters in the most recent Reuters poll remain pessimistic on the euro, foreseeing it at $1.35 at the end of February and at $1.28 in a year. FOREXPOLL01
Paresh Upadhyaya, director of currency at Pioneer Investments in Boston, which had assets under management of $204 billion as of the end of last year, said the euro is overvalued, with a fair value of $1.17 to $1.20.
Still, he said the euro could outperform in the near term and hit $1.40 as markets focus on balance sheet and interest rate differentials. His firm currently doesn't have any direct exposure to the euro.
A strong currency may stifle Europe's exports and hurt an economy still suffering from the tough austerity measures imposed by governments to bring down debt. France has complained about the euro's level, although Germany said the currency was not overvalued.
The euro was last near $1.50 in May 2011. Similar to the current trend, the euro's ascent back then was largely driven by the contrasting monetary policy stances of the Fed and ECB.
A near-term risk for euro bulls is the ECB meeting on Thursday and whether ECB President Draghi expresses concern about the currency's recent gains.
Stephen Jen, managing partner at hedge fund SLJ Macro Partners in London, said it is not likely that Draghi will say much about the euro this time. In 2009, Draghi's predecessor, Jean-Claude Trichet, waited until the euro hit $1.50 before describing the move as "brutal," he said.
Jen, who declined to disclose his firm's position, said his study showed that an overvalued euro is "not very damaging" to the euro zone because two-thirds of European countries' trade is with each other.
(Reporting By Julie Haviv and Wanfeng Zhou; Editing by Steve Orlofsky)