Euro traders trust Trichet as ECB bails out EU leaders

Bloomberg/New York

Trichet and his policy makers have bought government bonds in an effort to contain borrowing costs

Foreign exchange traders are putting their faith in Jean-Claude Trichet, betting the European Central Bank president will save the euro from a collapse predicted by everyone from George Soros to Paul Volcker.While the region’s debt crisis now threatens Italy and Spain after infecting Greece, Ireland and Portugal, the euro has appreciated 1.8% this year against a basket of nine developed-nation counterparts, according to data compiled by Bloomberg.Only the Swiss franc has done better. The currency shared by 17 countries gained last week as financial markets were roiled by further evidence that the global economic recovery is weakening.The strength underscores confidence in Trichet’s ability to prop up the currency until government officials reach a long-term agreement to reduce the region’s expanding budget deficits after Greece, Ireland and Portugal had their credit ratings cut to below investment grade.The ECB’s solution has been to buy government bonds, driving yields lower, and then draining the extra euros pumped into the financial system by the purchases before it can spark inflation.“A lot of people are scratching their heads and wondering why the euro has been so resilient and it’s because the ECB stepped in the market and took the pressure off the European banking system,” said Paresh Upadhyaya, head of Americas G-10 currency strategy at Bank of America Corporation in New York, who estimates the euro will end the year at $1.45.“That in turn helped support the euro and is why the euro is on the cusp of breaking $1.45 instead of on the cusp of breaking $1.40.”The euro strengthened 1.1% last week to $1.4397, and gained 2% to 1.1303 versus the franc. A Bloomberg Correlation-Weighted Index tracking the euro’s performance rose to 99.9616 last week from 98.2357 at the end of 2010. It has gained against every major currency except the Swiss franc this year.Strategists have increased their year-end forecast for the euro versus the dollar by 9.2% since January, according to Bloomberg data.Trichet and his policy makers have bought government bonds in an effort to contain borrowing costs before a plan by European Union leaders goes into effect.EU leaders last month proposed expanding the role of the €440bn ($633bn) European Financial Stability Facility – the fund that has helped bail out Greece, Ireland and Portugal – to buy bonds in the secondary markets, aid troubled banks and offer lines of credit. The plan will go into effect after the parliaments of member nations approve it.ECB data show it bought €22bn of government bonds in the week ended August 12. It purchased an undisclosed amount last week. Besides buying debt, Trichet extended the central bank’s unlimited lending to financial institutions through year-end to ease financial market tensions.Ten-year yields on Italian and Spanish bonds closed last week at 4.93% and 4.97%, after surging as high as 6.4% and 6.5% in the first week of August.Unlike the Federal Reserve, the ECB mops up the extra currency it creates through a programme known as sterilisation. It does that by auctioning seven-day term deposits from banks. The Fed’s $2.35tn in bond purchases, known as quantitative easing, went unsterilised, inflating the supply of dollars.“The euro has held up exceptionally well, unbelievably well,” said Lane Newman, director of foreign exchange at ING Groep in New York.“The euro at times has done badly against other currencies but it has held up very well against the dollar because of the fact that now the ECB and the rest of the European finance ministers put a backstop under it.”Bank of New York Mellon, the world’s largest custodial bank with more than $26tn in assets under administration, has seen more money pouring into the euro by some of its largest customers, said Samarjit Shankar, a managing director for the foreign exchange group in Boston.Flows were as much as 1-1/2 times higher last week than the weekly average over the past year, according to Bank of New York’s data, which is used by the International Monetary Fund and the Bank of Japan in their analysis.Euro inflows in the week through August 12 were 95% greater than previous weeks over the past two years, Morgan Stanley reported last Monday.The firm’s clients were “very heavy buyers” in the past year, said Calvin Tse, a London-based currency strategist at Morgan Stanley.Rather than a referendum on the euro, the currency’s strength may reflect the dollar’s weakness, according to Camilla Sutton, a Bank of Nova Scotia currency strategist in Toronto. Sutton expects the euro to strengthen to $1.50 this year as lawmakers in the US struggle to reach consensus on spending cuts and a long-term budget plan.“The expectation is that the US dollar will weaken based on having a particularly loose monetary policy at the Fed as well as having no credible plan in place nor a political will to get one,” Sutton said.