Euro bulls take heart from ECB currency talk

Mon Oct 7, 2013 1:26pm BST

* Market had expected more aggressive talking down of euro

* Tighter liquidity conditions could push currency higher

* Euro/dlr 1-mth risk reversals indicate euro may gain more

* U.S. shutdown and debt worries underpinning euro

By Anirban Nag

LONDON, Oct 7 (Reuters) - After what was seen as a lukewarm protest against a strengthening euro by European Central Bank chief Mario Draghi last week, financial markets are gunning for more gains for the single currency.

On the face of it, the bank has done much on actual policy to lay the ground for a halt in the currency's gains, allying an extremely cautious view on the euro zone's recovery to a promise to pump yet more money into the banking system if market interest rates show even a hint of rising.

But many in financial markets are more interested in the contrast between President Mario Draghi's line on the currency last Wednesday and what the bank said when it was last this strong in February.

Then, the ECB inserted into its statement a clear expression of concern over the exchange rate's cooling impact on growth and prices. There was no such line this time - and while Draghi himself again noted the relationship with growth, there was no explicit warning that the euro was harming economic activity.

Some strategists believe the bank may be less concerned about the currency this time round because money market rates are low - in stark contrast to February, when they were rising.

"At that time, the ECB was fighting the upward trend in money market rates, which it deems it must control tightly to foster any sort of durable economic recovery," said Tom Levinson, currency strategist at ING.

"It is the decline in money market rates in recent weeks that potentially made (ECB President Mario) Draghi's mind up not to be more aggressive."

U.S. TIME BOMB

The euro's prospects in general have changed dramatically since Draghi's landmark statement a year ago that the bank would do all that was needed to defend the single currency project.

The euro area, driven back into recession by the debt and banking problems of its southern members, looks set to register its second quarter running of minimal but solid growth. Worries over the collapse of Italy's government have receded for now.

Ireland is getting ready to be the first bailed out government to get back to market financing. Even Greece is hopeful of emerging from recession.

Add to that in the past week the prospect of a historic U.S. debt default that would make the single currency a haven for investors seeking safety for their money away from the dollar.

"The closer we get to this kind of scenario, the more we would expect the world to divide into a flight to safe haven currencies, with yen, Swiss franc, the euro, and sterling preferred in that order," said Alan Ruskin, currency strategist at Deutsche Bank, adding the euro could hit $1.40.

A surge to those sort of levels, last seen two years ago, is expected to galvanise the ECB policymakers to intervene verbally. Some analysts expect the ECB to start jaw boning even before that given that the euro on a trade-weighted basis is already at a two-year high.

"We would expect the ECB to speak about the exchange rate once it is around $1.38 as it does lead to tighter conditions," said Manuel Oliveri, FX strategist at Credit Agricole. The bank has a buy on the euro with a short term target of $1.3830.

FORWARDS

A few weeks ago the ECB said it was ready to offer more long-term loans to banks to keep money-market rates from rising. Many saw this as a covert attempt to push the euro, which has gained about 4 percent in the past month, lower.

Euro zone money market rates, in part as a result, are below February highs. The one-year, one-year forward Eonia rate, one of the most traded money market instruments which shows where one-year euro overnight rates are seen in a year's time, are at 0.35 percent, well below February highs of 0.475 percent.

One-month euro/dollar risk reversals, a measure of relative demand for options on a currency rising or falling, on the other hand are showing a bias for more euro gains.

"The euro has momentum to rise towards $1.37 in the short term as ECB policy right now is not directed towards the exchange rate," said Francesco Scotto, portfolio manager at RTFX Fund Management.