Euro's natural drivers restrained by Greek crisis

Barely a day goes past on foreign exchange markets when the euro does not suddenly jump or fall on a newspaper report - accurate or otherwise - about the latest plan for a bailout of Greek debt.
Early on Wednesday, for example, the euro moved upwards with traders citing a Greek newspaper report that the European Union/International Monetary Fund mission in Athens would complete its report on Thursday.
There was nothing new in the report, but traders nonetheless cited it as a mover.
A little later in the session, a German newspaper report that the IMF was not going to pay its next tranche of aid - in the event, overstated - led to the euro weakening, later to reverse.
Such moves stand in contrast with other markets, which, like government bonds, appear to have priced in a Greek debt restructuring, or, like equities, move in risk-on, risk-off sentiment waves rather than sudden spikes. The behaviour of the euro in part simply reflects the nature of foreign exchange trading - driven by short-term speculation. But it also points to an underlying stress in the market in which the debt crisis is stopping the common currency from taking full advantage of favourable interest-rate differentials.
The result is that euro/dollar implied volatilty has risen since mid-May from less than 11 percent to roughly 13 percent, the highest since January.
By contrast, volatility in eurozone blue chip stocks dropped sharply in late May and even at its monthly high was well below recent spikes.
What has been happening is a confluence between normal foreign exchange behaviour and the rise in concern over Greece's ability to meet its debt obligations despite existing bailout plans.
In the first case, foreign exchange trading is nearly always subject to sharp moves.
"Eighty percent of all movements in currency markets are speculative," said Clive Lennox, head of foreign exchange trading at brokerage Clear Currency. "They are driven by people betting on direction." In the current circumstances, however, it could be argued that appropriate direction for euro/dollar would be up.
Indeed, only a few weeks ago the euro had rallied close to $1.50, primarily driven by the European Central Bank's decision to raise interest rates and lean towards more.
The dollar by contrast was undermined by continued easy money from the US Federal Reserve, little prospect of near-term tightening, and a poor US fiscal situation. Questions about the eurozone, however, have led to the euro to slide from its heights.
"Right now we have had a decent correction from $1.49 down to $1.40. The market is hesitating," said Audrey Childe-Freeman, EMEA head of currency at JPMorgan Private Bank.
The extent of this turnaround can be seen in the latest data from the Commodity Futures Trading Commission. It shows 61,447 net long euro contracts in the week of May 10 turning into just 19,129 in the week of May 24.
The underlying interest rate and fiscal differentials that took the euro close to $1.50, however, remain in place. So the shift in the market reflects nerves over the ins and outs of the Greek debt saga and the threat of contagion it poses.
"If it weren't for the euro zone debt crisis, euro/dollar would be trading at $1.66," Royal Bank of Canada said in a note. Hence any hint that the situation might be getting better or worse is having a disproportionate effect on traders who are arguably positioned against fundamentals. So a report that adds little to the debate - for example, one simply stating when an EU/IMF meeting will end - or that is even wrong, carries far more weight that it normally would. Childe-Freeman reckons this will end soon as the Greek debt negotiations work their way to a conclusion.
"We will go back to the theme that drove the euro high, namely the interest rate differential and the US fiscal position lingering in the background," she said.