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Did Mario Draghi Just Kill the Rally in the Euro?

Friday, 7 Dec 2012 | 12:32 AM ET
Sabine Scheckel | The Image Bank | Getty Images

The euro, which has been remarkably resilient recently, saw a major selloff leading to its biggest one-day loss in a month after the European Central Bank (ECB) slashed its growth estimates for this year and next, and hinted at a possible rate cut in 2013.

Despite this setback, foreign exchange strategists expect the single currency to bounce back quickly. They see the euro supported by worries over the looming "fiscal cliff" of tax hikes and spending cuts in the U.S. and uncertainty over what the Federal Reserve's next move will be after its bond buying program, "Operation Twist" - which involves selling medium-term bonds and using the proceeds to buy longer-term ones - comes to an end on December 31.

(Read more: After the Fed's "Twist" Comes the Hard Turn)

"We don't think ECB President Draghi has completely killed the rally in the euro, the currency pair has had a very nice run over the past few weeks and a correction is not unexpected," said Kathy Lien, managing director of forex strategy for BK Asset Management.

ECB chief Mario Draghi on Thursday painted a bleak outlook for the currency bloc's economy and said policymakers had discussed negative deposit rates, prompting a steep fall in the euro.

The euro, which has risen over 5 percent against the U.S. dollar since August, was trading near multi-month highs against major currencies including the greenback, British pound and Japanese yen on Thursday, giving rise to profit taking overnight.

"The euro had been built up, so yesterday's (Thursday's) move also reflected some profit taking," Mitul Kotecha, head of global foreign exchange strategy at Credit Agricole, who expects the single currency to end the year at $1.30.

Besides uncertainty around whether the U.S. will manage to avoid the $600 billion "fiscal cliff" in January - which is negative for the dollar - Kotecha said the euro will also see some support from central bank buying.

"We've seen more flows from central banks - probably a result of reserve reallocations for the new year - which will help support the currency," he said.

Barclays' technical analyst Dhiren Sarin, who expects "choppy gains" in euro-dollar over the next one-two months, said support areas for the single currency are $1.2875 and then the 200-day average of $1.2790.

Euro-US Dollar 6 Month Chart

Boost From Equities

"We see this as a one to two month phenomenon, but thereafter the outlook is less clear and can't rule out a stronger pullback," Sarin said

He also expects the currency will move higher in the near-term, helped by continued flows into European equity markets, due to their recent outperformance relative to U.S. markets.

Over the past three months, major European markets including France'sCAC 40 index and Germany's Dax 30 index have risen 2.6 percent and 5.1 percent, respectively, compared to a decline of 1.3 percent for the U.S.'s S&P 500.

Euro in 2013

While the euro is expected to remain resilient in the near-term, the outlook for the currency over the next 12 months is less upbeat.

"We expect the euro to rise to $1.32-1.35 in the next quarter, but as we move through to the second quarter, we will be increasingly debating the U.S. recovery. If there is a sense that growth may be starting to recover faster than expected, this could be negative for the euro," said Robert Rennie, chief currency strategist at Westpac Institutional Bank, adding that the euro-dollar could fall to $1.25 in the second-half of 2013.

Michael Woolfolk, senior currency strategist, BNY Mellon, who is less optimistic on the prospects for the euro over both the short and medium-term, said 12 months out, he sees the currency below $1.20.

In the short-term, he said the U.S. dollar will gain favor due to risk aversion in the markets. "Expect to see between now and the end of this year some further risk coming off the table. You want to be long dollars going into the last several weeks of the year."

Over the medium-term, he expects the ECB will lower interest rates, which would be negative for the single currency.

"Draghi is very much in keeping with the G7 (nations) in supporting aggressive monetary easing, so there will be lower rates in Europe next year – it's just a matter of time," he said.

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