By Naomi Tajitsu
LONDON (Reuters) - A darkening euro zone economic outlook, a shrinking interest rate advantage and skepticism over European authorities' ability to resolve the sovereign debt crisis have raised the risk the euro will fall toward $1.30 before year-end.
The single currency has already broken below $1.40 -- a level around which sovereign demand has been clustered -- and plumbed a six-month low around $1.3790 on Friday after the European Central Bank on Thursday signaled a halt to its policy tightening.
A near 5 percent fall in the euro against the dollar in the 10 days reflects investor concern over the stability of fiscally weak euro zone countries, including Greece and Italy, which in turn has shaken confidence in the region's banking system.
Greg Anderson, an FX strategist at Citi in New York, saw more downside for the euro unless the global growth outlook improved and investors were persuaded Europe was making lasting progress toward resolving the sovereign debt crisis.
"As it stands right now the euro is falling for a reason and neither of those variables look good at the moment. Could we have a move below $1.30 (this year)? It's definitely possible."
Market participants said long-term investors have dumped the euro in the past month despite mounting speculation the United States will introduce more quantitative easing, which is often dollar negative.
Data from UBS on its client flows shows asset managers were big sellers of the euro last week, while hedge funds also shed the single currency.
"Real money has been quite specific and it's all euro downside at this stage," said Geoffrey Yu, FX strategist at the Swiss bank, which sees the euro at $1.35 in three months.
Until this week's break, the euro had held in a $1.40-1.47 range for much of the year despite market disappointment over European officials' efforts to help fiscally weak euro zone countries. It is up nearly 4 percent on the year.
It made a strong push below $1.40 on Thursday after the European Central Bank tempered its stance on inflation risks, signaling a halt to its cycle of interest rate rises.
That removed what little support the euro had enjoyed on the prospect of a widening rate advantage.
While the ECB said it would keep buying bonds to curb borrowing costs for peripheral debt countries, many believe sentiment toward the euro will sour as policymakers dither in implementing permanent measures to stop the debt contagion.
"The ECB did sound dovish, and opened the door for rate cuts and further provision of liquidity to banks," said Henrik Gullberg, FX strategist at Deutsche.
He said the euro could recover above $1.40 if the ECB continued to buy government bonds of fiscally weak countries to stabilize their debt markets and if the global economy improved through year-end.
But he added, "If we see a sustained break of the $1.40-1.45 range, we could see the euro establish a $1.35-1.40 range.
"That is likely to happen if we see a sustained deterioration in data and European authorities continuing to be reactive rather than proactive."
Technical signals suggest the euro faces more selling after a break on Friday of $1.3837, a low hit in July and which had been seen as a key support level. A daily close below that level could open the way to $1.3769, the 38.2 percent retracement of the euro's June 2010-May 2011 rally.
Indeed, investors in the options market are pricing in chances of more downside risks to the euro.
One-month implied volatility is hovering near its highest of the year, while the skew between bets to sell or buy the euro has jumped to a record high of 3.9 in favor of euro selling this week. This suggests investors still see a premium on bets to sell the single currency.
Central bank buying, which has supported the euro in recent months, could also be set to weaken.
While the Swiss National Bank's decision to set a floor this week for the euro/Swiss franc pair at 1.2000 requires it to sell francs for euros, it is highly likely to recycle them into other currencies, potentially pushing the euro lower.
Asian sovereign investors have bought the euro in recent months each time it has dropped below $1.40.
Asian central banks, particularly China, with the world's biggest FX reserves, are likely to keep buying the euro and other currencies to diversify their holdings away from dollars, but their buying pace may slow.
Slower growth in China and appreciation in the yuan will also pare growth in China's currency reserves.
"China's diversification will continue, but their need to diversify will slow down," Stannard said, adding that this would be a factor in the euro's fall to $1.36 by the end of the year.
(Editing by Nigel Stephenson)