The euro rose sharply against the dollar on Friday after European leaders agreed on action to lower the borrowing costs of Italy and Spain and create a single supervisory body for euro area banks.
Analysts said that expectations before the meeting had been so low that the positive outcome wrongfooted investors who had positioned for the euro to weaken. They had to row back on those bets after the surprise early-hours deal.
They said the euro could make further near-term gains, supported also by month- and quarter-end flows, but expected the rally to fade next week as investors worry some steps are just short-term solutions and others will take time to implement.
The euro soared more than 1.2 percent on a flurry of stop-loss buying to as high as $1.2628, pulling well above a low of 1.2407 marked on Thursday and leaving it on course for its biggest daily rise in eight months. It was last at $1.2583.
Leaders of the 17-nation euro zone surprised markets by allowing the euro zone’s rescue fund to be used to stabilise bond markets without forcing countries that comply with EU budget rules to adopt tough austerity measures.
“A few things have removed some of the fear, which is why we have seen the euro move higher. I wouldn’t be surprised to see it move up further in the very near term as we had quite downbeat sentiment ahead of the summit,” said Ian Stannard, head of European currency strategy at Morgan Stanley.
However, he did not expect it to rise much beyond $1.27. “It will not be too long before the market realises there is not much new in the agreement, and that anything that is new has a huge amount of conditionality in it.”
The euro could struggle ahead of chart resistance at the $1.2748 June high. Near-term support was at the 21-day moving average at $1.2543 with stop loss sell orders reported below.
Some analysts pointed to execution risks in the move to empower the ECB with a supervisory role that could prove to be contentious. The market would also soon start to question whether the euro zone’s rescue fund has enough resources to recapitalise banks and buy peripheral bonds.
While these issues may return to weigh on the euro in the coming days, traders said for now the common currency was being supported by falling Spanish and Italian bond yields. European stocks also rose.
“The proposed changes to the EFSF/ESM (rescue funds) have come as a surprise and these are bringing down euro zone peripheral bond spreads and pushing the dollar and the yen lower,” said John Hardy, currency strategist at Saxo Bank.
“But structural issues remain; the question whether greater fiscal integration can be achieved is still there.”
In a concession by European paymaster Germany, euro zone leaders agreed the bloc’s future permanent bailout fund, the European Stability Mechanism (ESM), would be able to lend directly to recapitalise banks without increasing a country’s budget deficit, and without preferential seniority status.
This removed a major concern that had put pressure on Spanish government bonds because investors were concerned the ESM would get paid before private bondholders in the event of a default by Spain.
Short term bounce
Reflecting easing concerns about the prospect of more euro falls in the options market, euro/dollar one-month volatility dropped to around 10.1 from 10.5 on Thursday.
Chartists said although the euro rose sharply it failed to move decisively above immediate resistance at $1.2617 - the 61.8 percent retracement of its decline over the past two weeks.
Next week, attention will turn to an ECB meeting, where an increasing number of analysts expect policymakers to opt to cut interest rates from their current 1 percent.
Against the yen, the euro jumped 1.4 percent to a one-week high of 100.525 yen, pulling away from a low of 98.37 plumbed on Thursday. It was last at 100.02 yen.
The growth-linked Australian dollar jumped around 1.5 percent to a one-week high of $1.0177.
With risk currencies rising, the dollar index - which measures its value against a basket of major currencies - dropped to a one-week low of 81.816, before steadying to 82.031.