Greatest Near Term Risk for Euro

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Since the beginning of the second quarter, the euro has been in a one-way downtrend against the U.S. dollar. During that time, the EUR/USD lost nearly 9 percent of its value. The culprit is obviously Europe’s sovereign debt crisis, which started back in 2009 but didn’t really become a focus until April 2010 when Greece asked for its first bailout. Then came Ireland in November of that year, followed by Portugal in April 2011, a second Greek bailout that same year and then a Spanish bank bailout request in June 2012. With the EUR/USD now trading at a 2.5 year low, there’s no doubt that the greatest risk for the euro is a Spanish sovereign bailout. This is the number one concern because Europe cannot afford to bail out Spain and yet investors believe that a full-scale bailout is inevitable. There will be no answer to the question of Bailout or No Bailout for the Country of Spain in the coming weeks but investors will form their own opinions and positions based on the movement in Spanish bond yields. The higher 10 year yields rise, the greater the pressure on the country’s finances and the EUR/USD.

Yet it may be weeks before the Spanish government succumbs to market pressure (if at all) and in the meantime, the greatest near term risk for the euro is a downgrade by Moody’s or S&P. Independent rating agency Egan Jones, which many professional investors argue is the only reputable rating agency left slashed Spain’s rating on Friday from CCC- to CC+ and said the chance of a default over the next year is 35%. Moody’s is currently reviewing Spain for a downgrade and if they follow through, Spain would officially be rated junk by one of the major agencies. However a ratings action from S&P could also come before a move by Moody’s because S&P rates Spain 2 notches above Moody’s and 1 notch above Fitch, who downgraded the country last month. The last action from S&P was a downgrade in April so a review is long overdue especially given recent developments. Rising borrowing costs, riots, request for financial aid by Valencia, the nation’s third largest city and the possibility of senior bondholders being subject to losses are just some of the reasons why Spain could be downgraded.

The market never handles downgrades well especially in an environment where the investors are already nervous and any piece of bad news could set off another a wave of selling. With an unemployment rate of 24.6%, there’s very little hope that Spain can fix herself. This week’s economic reports are not expected to be much help since growth is as much of a problem as fiscal finances. The only way that the EUR/USD will bottom is if there are some positive developments on the policy front. Unfortunately the next ECB meeting isn’t for another 2 weeks and the next Eurogroup meeting isn’t for another 2 months. This means the EUR/USD should remain under pressure and the break of the former low of 1.2167 now opens the door for a move down to the psychologically significant 1.20 level.

Kathy Lien
Managing Director

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