Returning funds may slow euro slide versus Fed-boosted dollar

06/26/2013

* Sell-off in emerging markets pushes money back into euros

* Inflows seen temporary shield for euro versus dollar

* Sharp falls seen later in 2013 on US/euro zone divergence

* Speculators' bets no longer favour the euro

By Jessica Mortimer

LONDON, June 26 (Reuters) - The euro should hold up well against the dollar in the coming months, supported by investors fleeing riskier currencies, before an expected reduction of U.S. monetary stimulus drags it lower by year-end.

Analysts said the euro has, to some extent, been shielded from unresolved problems within the euro zone by money flowing out of emerging and commodity-linked currencies.

But they said the Federal Reserve's plan to slow its stimulus later this year - a stark contrast with the possibility of further interest rate cuts from the European Central Bank - should eventually see strong gains for the dollar.

The Fed announcement has already toppled the euro off a four-month peak above $1.34 to close to $1.30 in just a week, but any fall towards the mid-May low just below $1.28 is unlikely to be quick.

"The strength of the euro has caught people by surprise," said Nick Bullman, chairman of consultants CheckRisk, adding its strength was due largely to external factors.

Euro falls have been tempered by its emergence as a funding currency - one investors borrow in to fund riskier investments - due to low euro interest rates and ebbing concerns the currency could break up.

Higher U.S. bond yields have diminished the dollar's use in such a role and made repatriation into euros more attractive.

"Since January, the U.S. dollar's use as a funding tool has been sharply reduced," said Hans Redeker, head of Global FX strategy at Morgan Stanley, adding: "We've seen some minor use of the euro as a funding tool".

Traders said many in the market lost money by selling the euro when it fell below $1.29 in May in anticipation of a drop towards $1.25 or lower and investors wanting to bet on a weaker euro may be cautious.

The euro has also benefited from falls in higher-yielding currencies like the Australian dollar, which investors bought against euros at the height of the debt crisis.

"The unwinding of diversification trades has provided the euro with a decent degree of protection from the current even more bullish tone of the dollar," said Rabobank senior currency strategist Jane Foley.

The euro zone's large current account surplus adds to the single currency's appeal. Foley said this may prevent sustained falls below $1.30 until the fourth quarter, when an end to U.S. monetary easing is likely to be imminent.

RESILIENCE WILL WANE

The spread between U.S. and German 10-year bond yields is at its widest since April 2010, when the euro began a slide from $1.35 to below $1.19 by June 2010.

This time, the euro's falls are not expected to be as drastic. But some analysts warn the euro's resilience is waning.

"The risk premium priced into the euro is very slim at the moment. There's almost nothing (priced in) in terms of the euro zone sovereign debt crisis," said Chris Turner, head of currency strategy at ING.

The euro's gains in recent weeks were partly due to investors reversing huge bets on dollar gains and euro falls they had accumulated early in 2013.

But these bets have been cut dramatically. Speculators now hold net "long" positions in the euro and may be looking for opportunities to sell.

"When the market isn't as short of the euro then the bad news (out of the euro zone) should come as more of a blow," said Rabobank's Foley.

The borrowing costs of indebted countries such as Spain and Italy have risen recently, while concerns have reemerged about funding problems in Greece.

"There's a real sense that everyone wants to short the euro. People realise that the main problems have not gone away, so it will be a bandwagon when it happens," CheckRisk's Bullman said.

A Reuters poll this month showed currency analysts see the euro at $1.26 in six months and $1.24 in 12.



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