FOREX-Euro rally pauses on brewing political worries

Mon Feb 4, 2013 7:52pm IST

* Euro falls on political worries, Spain data

* Euro investors cautious before ECB meeting

* Dollar rises to fresh 2-1/2-year high against yen

* Expectations of more easing keep pressure on yen

NEW YORK, Feb 4 (Reuters) - The euro slipped from multi-month highs against the yen and dollar on Monday as most investors bet recent gains had gone too far, too fast ahead of a European Central Bank meeting this week and due to political uncertainty in Spain and Italy.

Weak Spanish unemployment data and a smaller-than-expected improvement in a euro zone investor sentiment index added to the drag on the common currency.

Spanish bond yields rose sharply on news Spain's prime minister Mariano Rajoy was facing increasing calls to resign on corruption charges. Polls showing Italy's former prime minister Silvio Berlusconi regaining ground before elections later this month added to investor concerns.

"The prospect of Rajoy's resignation has roiled the markets as any fresh political instability in (the) euro zone's most important periphery economy could undermine the sense of investor confidence and send Spanish yields higher, making it much more difficult for the government to implement its austerity measures," said Boris Schlossberg, managing director of FX strategy at BK Asset Management in New York.

The euro traded at $1.3571, down 0.5 percent on the day, having hit a session low of $1.3547. It fell past stop loss orders below $1.3570 with more stops cited below $1.3550.

But the euro's dip may prove temporary, strategists said, and it could resume its move up if the ECB expressed no concern about the currency's recent gains at a news conference after its interest rate decision on Thursday.

The euro had risen to $1.3711 on Friday, a level unseen since late 2011. The euro remains up 2.7 percent for the year.

Against the yen, the euro was down 0.7 percent at 125.88 yen , off a 33-month high of 126.96 yen struck last week.

One reason for the euro's outperformance has been the ECB's relatively upbeat view on the euro zone economy. It has been the only major central bank to withdraw some of its unconventional monetary stimulus while the Bank of Japan and the U.S. Federal Reserve are expanding their balance sheets.

Monetary stimulus or balance sheet expansion usually hurts a currency as it increases its supply.

"Once the ECB fails to cut rates on Thursday, which is our view, the euro will be free to move higher again, but with the uncertainty surrounding the meeting the euro will likely weaken slightly or trade sideways," said Adam Myers, senior FX strategist at Credit Agricole in London.

YEN WEAKNESS

The dollar touched a fresh 2-1/2 year high of 93.18 yen, breaking through reported options barriers at 93 yen. More barriers were reported at 93.25 yen and 93.50 yen. The U.S. currency was last at 92.64 yen.

"The yen will remain weak, though it will likely not be sold at the momentum seen last week," said Myers, who added that investors would be looking to buy the euro and dollar against the yen on dips.

Sentiment towards the yen is negative as the BOJ is expected to remain under pressure to ease policy aggressively.

Analysts said Japanese portfolio managers were also looking to review their allocations after the change in monetary policy, and that could prompt more outflows from Japan and weigh on the yen.

"A reduction in the high level of JGB (Japanese Government Bonds) exposure traditionally held by Japanese funds will have both short-term and long-term negative effects on the yen, in our view," analysts at Morgan Stanley said in a note.

"We maintain our dollar/yen long position."

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