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EU debt plans and positive US growth won’t sustain euro rally

The euro’s gains will be limited as markets await details on key areas of the eurozone debt crisis plan. The inevitable implementation risks of a long-term solution, coupled with bleak European growth prospects and a likely ECB rate cut will weigh on the single currency.

EURUSD rose 2% on Thursday, breaking the 1.40 barrier for the first time since September 6, as the risk of involuntary Greek default receded after private sector agreement to a 50% write-down on Greek debt. That was accompanied by plans to recapitalize European banks and leverage the European Financial Stability Facility. EURUSD swiftly extended gains, testing 1.4245, an eight-week high, as equity markets soared on the back of relatively strong third-quarter US GDP data that showed the economy grew at an annualized rate of 2.5%, its fastest pace in a year. However, the gains in EURUSD were not because of a sudden reversal in euro bearishness but rather part of a broad risk-on move as investors abandoned the US dollar in favour of risk assets. Market positioning data, suggests this was the case.

“The path we saw yesterday wasn’t really reflected in our euro positioning data, which would suggest to me that there is no real outright EURUSD dollar position here,” says Henrik Gullberg, an FX strategist at Deutsche Bank in London, adding that there only slight unwinding of euro shorts.

While the move away from dollar longs has benefited the euro, its advance has in fact lagged the gains in risk assets and other pro-cyclical currencies as investors remain cautious. Ian Stannard, head of European FX strategy at Morgan Stanley, says further gains will be limited until more details on key areas of the EU’s plans are announced.

“If the EU is able to secure the required level of outside investment, that would be a positive for the euro in the form of a fresh injection of capital. But beyond that there is not much in the plan that is an outright positive for the euro,” Stannard says.

The euro is still vulnerable to the bleak economic outlook, regardless of political developments to contain the eurozone debt crisis. A sharp decline in European flash PMIs, especially the German manufacturing PMI’s fall below the psychologically important 50 level, is a warning signal of weak growth ahead. Indeed, concerns about recession seem to have become widespread.

 Eurozone PMI data signals 0.3% quarterly contraction in Q4
 Source: Morgan Stanley, Reuters Ecowin

“The weaker the growth prospects, the harder it will be to sort out Europe’s fiscal problems and the looser ECB policy is likely to be,” says Sara Yates, FX strategist at Barclays Capital, in a telephone interview on Friday. “The interest rate differential in the eurozone has been a key support for the euro; an aggressive rate cut will take away that pillar, paving the way for further downside.” Though the recent agreement from the EU’s Brussels summit may help stabilize some of the symptoms of the eurozone’s problems, longer-term political and implementation risks linger.

“The uncertainties remain acute and on a risk/reward basis the euro does not appear attractive,” a report from Barclays said yesterday.

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