‘All in’ bid to save euro only temporary, says UBS

Credit markets rallied around the world after the European Union agreed an aid package worth almost $1 trillion to halt the sovereign debt crisis.

“There has been a poker game going on between the markets and the EU,” said Gary Jenkins, head of credit strategy at Evolution Securities Ltd. in London. “This is probably reaching a climax as the EU has just gone ‘all in.’”

European policy makers stepped up efforts to prevent a sovereign-debt collapse and muffle speculation the 11-year-old euro could break apart. The measures came after contagion from Greece drove the common currency to a 14-month low, infecting the bank-funding system and threatening to slow the global economic recovery as borrowing costs rose from the U.S. to Asia.

The loan package offers as much as 750 billion euros ($962 billion), including International Monetary Fund backing, to countries facing instability, while the European Central Bank said it will buy government and private debt. The Federal Reserve authorized temporary currency swaps with other central banks in response to the “re-emergence of strains” in Europe.

“Politicians and the ECB have now pressed the nuclear option,” said Padhraic Garvey, a strategist at ING Groep NV in Amsterdam. “The central question from here is whether the cumulative measures can manage to stabilize the system.”

Stocks surged around the world, the euro strengthened and commodities gained today on the EU’s aid package. But the euro’s rally will be “temporary,” according to UBS AG, the second-largest currency trader.

Policy in the region is becoming “very unfavorable,” said Mansoor Mohi-uddin, Singapore-based global head of currency strategy at UBS. Investors should use gains in the euro to make fresh bets it will decline toward $1.20 within three months, according to Barclays Capital. Schneider Foreign Exchange cut its forecast for the euro, citing risks to the currency following the European Central Bank’s asset-purchase plan.

The European package may drive a “temporary rally” in the euro toward $1.35 before it resumes its decline, said Mohi- uddin. “The euro will definitely hit what we call its long-term fair value at $1.20 and it may easily overshoot that if difficulties in Europe persist,” he said. “The policy mix in Europe is becoming very unfavorable to the currency.”

The euro advanced as much as 2.7 percent to $1.3094 and was 2 percent higher at $1.3008 as of 11:30 a.m. in London. The currency tumbled 4.1 percent last week, the biggest drop since the five days to Oct. 24, 2008. The euro last traded at $1.20 in March 2006.

The European Central Bank said in a statement it will buy government and private bonds “to address severe tensions in certain market segments which are hampering the monetary policy transmission mechanism and thereby the effective conduct of monetary policy.”

The bank said the moves won’t affect monetary policy and the resulting liquidity will be reabsorbed.

“We remain euro bears,” David Forrester, a currency economist at Barclays Capital in Singapore, wrote in a note to clients. The agreement means “the ECB will have to play a larger role in terms of keeping monetary policy loose for longer in order to help euro area countries to grow out of their fiscal problems.”

At the same time, countries accessing the facilities would need to agree to fiscal consolidation measures, Forrester wrote. “This tight fiscal/easy monetary policy mix is likely to be negative for euro.”

Analysts have cut forecasts for where the euro will trade by June every month this year on speculation the region’s expansion will slow as nations from Greece to Portugal are forced to curb spending. The currency will trade at $1.33 in the second quarter, according to the median prediction.

Schneider lowered its forecast for the euro to $1.35 at the end of 2011, from a previous forecast of $1.45, Stephen Gallo, head of market analysis in London, wrote in a research note today. The euro will suffer from “ECB credibility risks, ECB balance sheet risks and EMU structural shifts,” he wrote. Schneider cut its forecast to $1.45 for the end of 2012, compared with the earlier prediction of $1.55.

The dollar slid as much as 3.6 percent on March 18 after the Federal Reserve said it would buy as much as $300 billion in Treasuries. The Bank of England and Japan’s central bank have also engaged in so-called quantitative easing.

“Medium-term we’d like to sell the euro against the dollar and against sterling as well, primarily because it looks like the BOE and Fed have finished QE, while the ECB is now embarking on a form of quantitative easing,” Mohi-uddin said.

The ECB will raise its main refinancing rate from a record low 1 percent in the first quarter of 2011, according to the median estimate of economists in a Bloomberg News survey.

“The shift from the ECB this weekend will have the market pondering the idea that the stance of the ECB will be far more accommodative than expected and for far longer, leaving the euro locked in its current downtrend,” Derek Halpenny, European head of currency research at Bank of Tokyo Mitsubishi UFJ Ltd. said today in an investor note.

Francesco Garzarelli, chief interest-rate strategist at Goldman Sachs Group Inc. in London, wrote that the effect on the euro “of a more restrictive fiscal policy and easy monetary stance is unclear.”

“As the risk premium erodes, the currency may extend gains against the dollar, returning it toward our $1.35 three- and six-month forecasts,” he said in a research report today.

Greek, Portuguese and Spanish bonds surged and German bunds slid today after the package of measures to tackle the Europe’s sovereign debt crisis.

Greece’s parliament on May 6 approved austerity measures demanded by the European Union and International Monetary Fund as a condition to secure a 110 billion-euro bailout that may deepen the nation’s yearlong recession.

Portugal is lowering its 2010 budget-deficit target to 7.3 percent from 8.3 percent of gross domestic product, Prime Minister Jose Socrates said May 8 in comments broadcast on RTP1 television. Spain has pledged to reduce the ratio to within the EU limit of 3 percent of GDP in 2013.

At 14.3 percent of gross domestic product, Ireland had the euro region’s largest deficit last year, followed by Greece at 13.6 percent and then Spain with 11.2 percent. That compares with an EU target of 3 percent.