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Foreign Exchange

Euro caught between dollar rock and Greek hard place

The euro was set to log its strongest weekly performance against the dollar for a month on Friday, but the currency is likely to tread water, analysts say, as investors weigh European debt concerns against the dubious attractions of buying the dollar.

Buyers of the European currency shrugged off prospects of a Greek debt default in recent days, putting a floor under recent declines, after the currency dropped from as high as $1.4830 on May 2 to $1.4048 on May 23.

The mini-revival echoed the bullishness around the currency earlier this year, as investors bet interest rates were set to rise faster than in the US. But appetite for the currency might be less a vote of confidence in Europe than a sign of concern over prospects for the world’s largest economy.

“The euro is benefiting not because it’s loved, but because it is less unloved than the dollar,” says David Bloom, global head of FX strategy at HSBC. “Both regions are facing economic crisis – but Europe is the only one doing something about it.”

While the dollar could rally on negative news flow around the European sovereign debt crisis, gains will be capped at around the $1.35 level, Bloom says, around the end of June.

Signs that US growth is likely to be tepid in the months ahead has prompted a re-rating of US interest rate expectations in recent weeks, as investors bet any Fed tightening is likely to be slower and later than previously expected.

The US economy grew at a weaker-than-expected annual 1.8% in the first three months of this year, the Commerce Department said this week, while the number of people out of work remained stubbornly high.

“Given what is happening in European peripherals, the euro should be a lot weaker,” says Paul Robinson, European head of FX research at Barclays . “It’s not because sentiment is being driven by the dollar.”

Although a rising number of economists are downgrading expectations for US growth, there is some doubt over the outlook, Robinson says, after March’s earthquake in Japan likely weighed on output.

Commodity prices remained a key driver of the dollar going forward, he says, with a resumed rising trend set to dampen demand for the US currency. Robinson sees the euro rising to $1.45 over the coming month, as a staging post on the way to $1.48.

However, gains in the euro are likely to be capped, analysts say, as investors fret over the debt crisis in Greece, which pushed the European currency to a record low against the Swiss franc in recent days.

“The euro will move higher if the Greek situation stabilizes but a restructuring remains the most likely scenario in the medium term,” says HSBC’s Bloom.

The cost of insuring Greek bonds against default rose to a record this week and the yield on the nation’s two-year and 10-year bonds increased the most since the euro was introduced in 1999, amid concern that the country would struggle to avoid a default, despite a €110 billion euro bailout last year from the European Union, the IMF and the European Central Bank.

AS the EU discussed a Greek debt rollover and fresh austerity measures, the European Commission estimated the country’s budget shortfall would be 9.5% this year, against debt of 158% of GDP, more than twice the EU’s 60% limit.

Implied volatility in euro dollar options peaked last year as the market faced up to the peripheral debt crisis, but has dropped sharply in recent months, suggesting that although the problems have not gone away, investors have digested the initial shock.

“If we can get through the next couple of months without a major problem in Europe then the euro is likely to track higher,” says George Saravelos, a currency strategist at Deutsche Bank. “But the most likely scenario is a move sideways and trade within a broad range of $1.30 to $1.50.”

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