NEW YORK: The euro fell the most against the dollar in almost two weeks on Thursday after the European Central Bank chief threw cold water on hopes of bold actions to contain the euro zone debt crisis.
Investors, however, refrained from selling the single currency more aggressively ahead of a key European Union summit on Friday. Signs of progress toward closer fiscal integration and more stringent budgetary discipline could temporarily boost market confidence and lift the euro.
In a press conference following the ECB's decision to cut interest rates by 25 basis points, President Mario Draghi discouraged expectations the bank would massively step up buying of government bonds.
He also said the euro zone's rescue fund should remain the main tool to fight bond market contagion, despite its clear limits, and that it was illegal for the ECB or national central banks to lend money to the IMF to buy euro zone bonds, appearing to veto one firefighting option under active consideration.
"Draghi refused to entertain the idea of using the central bank as a lender of last resort stating that this was against its mandate," said Boris Schlossberg, director of currency research at GFT in Jersey City.
"By refusing to act as a backstop to the euro zone sovereign debt market, the ECB may have created the worst of both worlds scenario by essentially lowering the credit quality of the euro without providing any interest rate relief for the member nations."
Yields on Italian and Spanish government bonds jumped after the ECB meeting. French and Belgian government bonds yields also rose but by less an those on Italian and Spanish debt.
Comments from Draghi that the decision to ease was not unanimous and that the bank did not consider cutting rates further also weighed on the euro. He also said the euro area is facing substantial downside risks.
Traders said the market perceived the easing of collateral requirements for euro zone banks as riskier because the ECB is lowering lending standards.
The euro fell to a session low of $1.3288 on Reuters data, its lowest since Nov. 30. It was last at $1.3338, down 0.6 percent. The euro also slipped 0.5 percent to 103.65 yen and 0.2 percent to 1.2357 Swiss francs.
The dollar rose 0.1 percent to 77.73 yen.
DOWNSIDE RISKS
The market's focus is now turning to Friday's EU Summit. France and Germany are pushing for rule changes to enforce stricter budget discipline, but a German official said Berlin is increasingly pessimistic about the chances of a deal.
Many in the market said the summit will fail to provide a fix to the sovereign debt crisis, which could see the euro extend its decline toward the $1.30 level.
"I think the market is setting itself up for a big disappointment, given that the expectation they're going to do something quite big -- change the treaty, what have you -- has been largely priced in," said Fabian Eliasson, vice president of currency sales at Mizuho Corporate Bank in New York.
"If they do that, we may get a fairly brief rally but then we'll slowly come to the realization that everyone is still broke and having trouble paying their bills," he said. "The potential downside (from the meeting) is much bigger."
In the options market, the 25 delta one-month risk reversals for euro/dollar traded around -3.10 vols with a bias for euro puts, compared with 2.75 vols on Wednesday, suggesting traders are more bearish on the single currency.
Implied volatilities rose to 14.30 percent, though still below their 50- and 100-day moving averages, suggesting that investors in general have become less pessimistic about the euro zone, with hedges coming down in price from previous highs.
Despite the ECB initiating measures to support bank lending and money market functioning, funding pressures in the euro zone increased..
The benchmark three-month cross-currency basis swap, a gauge of dollar demand corresponding to the relative premium for swapping euro LIBOR for dollar LIBOR, traded at -121.500 basis points, from -115 basis points on Wednesday.
Wider spreads typically reflect elevated demand to borrow US dollars in the currency forward market and often support the greenback's spot value against the euro.
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