Euro seen bolstered by banks repaying crisis loans

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(c) 2013, Bloomberg News.

The recovery in the euro area's exports and economy is in jeopardy as the region's currency gets a boost from lenders repaying crisis-era loans provided by the European Central Bank.

Since the beginning of May, commercial banks have paid back the equivalent of $57 billion borrowed under the ECB's Longer- Term Refinancing Operations program, data compiled by Bloomberg show. That helped shrink the central bank's balance-sheet assets to 2.4 trillion euros ($3.2 trillion), while the U.S. Federal Reserve's have increased to a record $3.6 trillion.

That almost $400 billion gap is the widest since member states established the ECB in 1998, and represents fewer euros in the financial system relative to dollars. ECB President Mario Draghi has refrained from printing euros to buy bonds and boost the region's economy, the opposite of the Fed's strategy.

"The ECB is less in control of its balance sheet, which has been shrinking in the context of other central banks," said Axel Merk, who oversees about $635 million of currencies as head of Palo Alto, Calif.-based Merk Investments LLC. "Like everybody else, the ECB would love to have a weak currency to boost exports. But the euro is cursed to rise."

Merk, whose Merk Hard Currency Fund returns have placed it in the 90th percentile of competing funds tracked by Bloomberg, is betting that the 17-nation euro will appreciate, he said in an Aug. 9 telephone interview. The median estimate of about 60 strategists and economists surveyed by Bloomberg is for the currency to end the year at $1.27, compared with $1.3348 as of 12:28 p.m. in London.

Europe's currency has risen 5.3 percent this year against a basket of 10 major currencies that includes the dollar, yen and pound, the biggest gain of any of its peers, according to Bloomberg Correlation-Weighted Indexes. It's up 10.3 percent over the past year.

The euro has managed to appreciate even as the region's economy has struggled. While the euro area emerged from a record-long recession in the second quarter, gross domestic product only grew 0.3 percent in the period, the European Union's statistics office said on Aug. 14.

Exports from the 17-nation bloc rose a seasonally adjusted 3 percent in June from May, when they dropped 2.6 percent, the EU said Aug. 16. Shipments from Germany, Europe's biggest economy, gained 6.3 percent, as those from France, the second- biggest, fell 1.7 percent.

The ECB started the LTRO in 2011, to provide short-term funds to banks shunned by investors as the sovereign-debt crisis escalated. Banks have borrowed about 1 trillion euros under the program.

The crisis has since abated, with money flowing back into the bonds of troubled nations and their banks. The Bloomberg Eurozone Sovereign Bond Index has rallied 19 percent from 2011 lows, compared with a 2 percent drop for the Bloomberg Global Developed Sovereign Bond Index.

Investors demand an extra 1.99 percentage points in yield to own bank bonds in euros, down from 4.49 percentage points at the start of 2012, according to the Bloomberg EUR Investment Grade European Corporate Bond Index Financials.

"You have these underlying flows that are euro-dollar supportive," Dan Dorrow, the head of research at Faros Trading LLC in Stamford, Connecticut, said in an Aug. 14 telephone interview. Dorrow forecasts the euro may appreciate to $1.40 by the end of 2013.

Instead of buying bonds in a policy known as quantitative easing, or QE, Draghi last month made what for the ECB was the unprecedented pledge to keep interest rates low for an extended period. The ECB is trying to persuade investors it has no plans to end its easy policy stance so that they, in turn, will keep longer-term rates low. That should pave the way for consumers and households to borrow cheaply and bolster economic activity.

The Fed is buying $85 billion of bonds a month, while the Bank of Japan is purchasing more than 7 trillion yen ($71.7 billion) of sovereign bonds on a monthly basis.

"There will be a good amount of QE going on globally for the next six months, while there is no sign of that in the euro zone," Darrow said.

The euro weakened 0.1 percent against the dollar last week. The shared currency is the second-best performer this year out of its 17 most-traded peers, with a 1.1 percent gain versus the greenback. It has slipped 2.6 percent since reaching a 14-month high of $1.3711 on Feb. 1.

The ECB could still raise rates if inflation pressure increases, the Bundesbank said Monday in its monthly report. The ECB's commitment "is not an imperative statement, and it doesn't represent a change" in its monetary policy stance, Germany's central bank said. "Forward guidance doesn't rule out an increase in the benchmark rate if greater inflation pressure emerges," according to the statement.

Option traders have turned more bearish on the euro versus the dollar as speculation mounts that the Fed will slow the pace of its bond purchases as soon as next month, boosting demand for the greenback.

Derivatives show traders are paying a 1.9 percent premium for options to sell the euro against the dollar on a one-year basis, near the most since July 4, data compiled by Bloomberg show.

"The Fed is going to taper because the U.S. economy is strong and can take it, while Europe is saying it's going to be slower in its response to rate hikes," said Robert Savage, the chief strategist at New York-based currency hedge fund FX Concepts LLC, which oversees more than $1 billion.

FX Concepts estimates that the euro will end the year between $1.25 and $1.27. The "risk of something bad going on in Europe" is higher "than something shockingly strong happening," Savage said in an Aug. 12 telephone interview.

The euro region's current-account surplus, the broadest measure of trade because it includes investments, was 16.9 billion euros at the end of May. Regardless of what happens with growth, the surplus will help bolster the euro, Merk said.

"If you have a current-account surplus, you don't even need economic growth to have a strong currency," Merk said. "You have a region that's less risky than it was before and an ECB balance sheet that's shrinking while the rest of the world is printing like crazy."