Euro Faces Sovereign Downgrades, Slowing Growth and Funding Crisis

Euro Faces Sovereign Downgrades, Slowing Growth and Funding Crisis

Fundamental Forecast for the Euro: Bearish

Fear of a liquidity troubles for Societe Generale and other banks stokes panicFrench and Spanish regulators break from the EU, ban short salesEURUSD maintains congestion better than most other majors, when will it break?

There is no lack of fundamental fears for the euro to collapse under. However, whether the currency actually tumbles or not depends on how ‘active’ these catalysts prove to be going forward. For the euro’s part this past week, we have seen the currency follow the expected lines of risk appetite trends. When set against the safe haven Swiss franc or funding-based Japanese yen, its bearish path has been unmistakable. Yet, against the high yield or investment currency group (Australian, New Zealand and Canadian dollars), the risk aversion effort has actually led the euro to a notable advance. This is an interesting point as we have to consider whether the euro is thereby considered safer than its more speculatively-appealing counterparts.

There are two different types of risk that the markets are generally concerned with: fundamental and speculative. Oftentimes the two overlap (and the former oftentimes leads to the latter). However, when we are talking about the euro, we are still dealing with a fundamental concern – one that seems to be simmering beneath the surface and therefore does not incite the panicked selling that has otherwise washed over so many other assets these past few weeks. However, we have seen a lack of immediate reaction build tension behind the euro before, only to lead the currency to a far more dramatic correction when sentiment finally caves.

In the week ahead, there are three prominent fundamental themes that we should be concerned about: a possible funding crisis; sovereign downgrades or liquidity issues; and a cooling of economic activity. This is the same order in which they should be ranked for their potential influence over price action. The market is exceptionally good at acclimating to changes in trading conditions. This is the primary reason why downgrades for Greece, Italy and other EU members in the past weeks have generated little in the way of consistent price action. However, when a previously unexpected development starts to come into view; the impact can be tremendous. This is the situation we are just now facing with the rumors of European banks funding troubles.

This past week, the panic was centered on Societe Generale as speculation that the French bank would soon need to receive a bailout. Later, this particular rumor was retracted; but the general health of the region’s funding situation and the market’s sensitive to the troubles are genuine. This past week, the ECB reported demand for overnight lending surged to 4.06 billion euros – reflecting either a specific bank that was at severe risk of liquidity shortage or many banks facing more moderate troubles. Either way, boosted liquidity demand, rising market rates, increased risk due to sovereign exposure (never thought I’d use that in a negative list) and a general decline in sentiment trends will create problems for the region’s banking system.

In the past week, we have seen the volume of headlines surrounding sovereign debt troubles taper off; but we can tell the market is still very interest in the topic. Though the ECB has revived its government bond purchases, this does not guarantee stability as the market is much larger in its selling scope than the central bank in its ability to purchase. We will keep a wary eye on Spanish and Italian yields specifically to see if they rally back despite the ECB’s intervention. Furthermore, after the French downgrade scare from this past week, the market’s will be even more concerned about the EU members at the top of totem pole.

From the docket, German, Spanish, Portuguese and Euro Zone GDP figures will fold into the bigger picture. Austerity efforts, financial stability and liquidity will all go out the window if an impending recession pulls the rug out from under the euro. – JK

Written by: John Kicklighter, Senior Currency Strategist for DailyFX.com

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