Contagion fears rattle euro

NEW YORK: The euro hit a four-month low against the dollar and another record low against the Swiss franc on Tuesday on fears euro zone leaders were failing to prevent a debt crisis from spreading.

Borrowing costs for Italy and Spain soared to 14-year highs as euro zone leaders conceded for the first time that Greece may have to default on some of its debt.

Investor fears that could ripple through Europe's banking system, putting pressure on stretched public finances in other euro zone countries. Italy, the euro zone's third largest economy, looks especially vulnerable: its debt-to-output ratio is second only to Greece and markets fear political bickering may derail a plan to slash spending and rein in the deficit.

"The market has woke-up to the fact that there's a much larger problem (than Greece). That's what precipitated the large fall (in the euro)," said Adam Myers, senior FX strategist at Credit Agricole CIB. "I very much doubt the European Central Bank, let alone the IMF, can bail out a country the size of Italy."

Spain is also in the line of fire on concerns about the ability of its banks to withstand losses on sovereign debt

Currency trading has been volatile, with the euro falling to a record low against the Swiss franc for a second straight day.

The franc is seen as a traditional safe haven in times of trouble.

The euro fell as low as $1.3835, a four-month low, though data showing a wider US trade deficit and talk that the ECB was buying euro zone debt sparked a short-squeeze that lifted it to $1.3989, down 0.3 percent from late Monday.

Plans for an emergency summit of policymakers on Friday to discuss the debt crisis also helped the euro recoup some of its losses, traders said.

Still, the common currency has shed more than 4 percent against the dollar this month, and market participants in London said there was a sense of panic on the trading floor.

"It's making for very chaotic trading," said Boris Schlossberg, director of research at GFT Forex. "We're moving on every headline from Europe right now."

One-month euro/dollar implied volatility rose to around 15 percent its highest since November 2010.

YEN GAINS, US DEBT DEBATE IN BACKGROUND

The yen, also considered a shelter from the storm, rose broadly, The dollar fell 0.9 percent to 79.47 yen, near its lowest since March. The euro shed 1.2 percent to 111.23 yen.

Sentiment toward the euro could change if the EU adopts what Steven Englander, head of G10 FX strategy at Citigroup, termed "the big bazooka approach:" a blanket guarantee on peripheral countries' debt, aggressive ECB buying of euro zone debt or a plan to create a common euro zone bond.

"It is likely that if one of these 'big' solutions is adopted, we would see the euro rally initially and perhaps sharply," he said. But "the question would be whether such proposals would be credible if Italy and Spain were under sustained pressure, since the potential sums would be extremely large and political opposition in the core far from trivial."

If the EU can calm markets, analysts said the focus could shift to the dollar and the US debt ceiling. Treasury has warned it may have to default on some debt if lawmakers don't agree to lift the legal US borrowing limit by Aug. 2.

All the uncertainty should keep the safe-haven Swiss franc in high demand, traders said, though Schlossberg noted that the trade has grown crowded and is vulnerable to correction.

Copyright Reuters, 2011