By Jamie McGeever
LONDON, March 19 (Reuters) - The euro is likely to bear the brunt of a drop in the dollar which seems guaranteed after the U.S. Federal Reserve unexpectedly announced plans to buy long-term government bonds by printing more money.
The Fed's move on Wednesday left the European Central Bank almost isolated among the Group of Seven central banks in not adopting quantitative easing, printing money to shore up the economy and avoid deflation.
This points to a stronger euro, which governments and exporters in the euro zone will not welcome.
Currencies of countries which have adopted quantitative easing -- Japan, Britain, Switzerland and now the United States -- have all fallen already. Supply of these currencies will rise and central bank purchases of bonds depresses nominal and real yields.
Quantitative easing (QE) involves the central bank buying assets from the private sector, including government bonds, to bring down rates across the curve. This should encourage lending, push private sector flows into "riskier" assets, and eventually reflate the economy.
For ideological, legal, political and logistical reasons, the ECB looks unlikely to adopt such a policy in the next few days or weeks, which suggests the euro's explosive rally following the Fed's announcement has further to run.
"The punishment for no QE is a higher currency," said David Bloom, global head of FX strategy at HSBC in London, sticking by his year-end target for the euro of $1.50.
That was certainly currency traders' initial reaction. The euro posted its biggest ever one-day rise against the dollar on Wednesday after the Fed's announcement, surging almost 4 percent to a 10-week high above $1.35.
That mirrored moves seen last week after the Swiss National Bank said it would intervene in the foreign exchanges to weaken the Swiss franc: the euro chalked up record gains against the Swiss currency, rising 3.5 percent on the day.
The euro has also risen around 6 percent against sterling since the BoE said two weeks ago it will buy UK gilts. All this means the trade-weighted euro is near a two-month high and could soon approach the record peaks hit late last year.
"The scale of the (Fed's) move is an absolute game-changer," said a senior foreign exchange trader in London. "A weak dollar is the natural corollary of the Fed's move and it won't matter what anyone else thinks -- euro zone policymakers will get a strong currency by default."
THE ONLY WAY IS UP
Euro zone policymakers, particularly politicians, are bound to bridle at this. A stronger exchange rate will erode the region's export competitiveness and threaten jobs in an already bleak economic environment.
But there seems to be little they can do to stop it, as long as the ECB refrains from adopting quantitative easing.
"Despite collapsing economic fundamentals, the euro is rising by default and the ECB is going to have to respond more aggressively than it thinks or even knows," said Nick Parsons, head of strategy at nabCapital in London.
"A strong currency will prove fatal for the European economy so, like it or not, the ECB will have to ease interest rate policy much more aggressively than they thought they would."
ECB officials, from President Jean-Claude Trichet down, have stated they will not cut the main interest rate to near zero, as the Fed, Bank of England, Bank of Japan and Swiss National Bank have all done.
They cut the ECB refinancing rate by half a percentage point to 1.5 percent this month. While another cut is expected, analysts see it falling no lower than 1 percent or 0.75 percent at most.
Instead, the ECB has cut the deposit rate, at which banks earn interest by parking funds at the ECB, to 0.5 percent, and allowed the euro overnight index average (EONIA) rate to stay some 75 basis points below the refi rate for several weeks.
The ECB argues that this constitutes aggressive action to lower interest rates and ensure credit courses again through the financial system.
Still, the ECB's reluctance or inability to take the steps taken by other major central banks, most crucially the purchase of government bonds, looks like it will lead to a stronger euro.
"U.S. rate differentials are turning much less dollar-supportive," Goldman Sachs said on Thursday. "We would extend our target on (a long euro/dollar) trade from $1.35 to $1.40." (Additional reporting by Kirsten Donovan)