Fundamental Forecast for Euro: Bearish

- ECB warns of loan losses, financial troubles for Europe going forward
- Overnight deposits with the ECB rise to a record high 320.4 billion euros as fear grows
- German employment improves for the 11th consecutive month

How can this happen to an economy that have been backed by a 750 billion euro guarantee? Having danced around a meaningful support level for two weeks (the midpoint of EURUSD’ historical range), the market’s most liquid currency pair finally took the next step down into the abyss. The fundamental drive for this unfavorable move: concern over the financial health and stability of the regional economic and monetary union. It may seem trivial that a European Union as peripheral as Hungary can pose a significant threat to the entire system; but the group is on such shaky ground that even a small spark can set off a disastrous fire. Is a serious default or the exit of a major EU member on the horizon? Will authorities actually move in to prevent such an event? The answer to these questions could define the future of the shared currency.

To be clear, the situation in the European Union has not improved materially over the past three or so weeks; it just so happens that risk aversion had eased and the regional economy was no longer the subject of constant scrutiny. This disregard of future uncertainties wouldn’t last for long though. Either conditions would have to materially improve or the reality of Europe’s situation would simply await the next tumble in sentiment. Naturally, with investors still adjusting to the reality that global growth was leveling off and yield forecasts were barren; it is no surprise that speculative assets and fundamentally weakened currencies would pitch lower. This time around, however, it was news from the Euro Zone that would catalyze sentiment rather than the other way around. Little more than a month in power, the new Hungarian government has said the former administration had “manipulated” figures and “lied” about the state of the economy. This has put the nation in a “grave” position; and it has been suggested that a default is not an exaggeration at this point. These are loaded comments when officials around the region are attempting to tread carefully. Clearly, anything less than cheerleading can accelerate disaster.

But what impact could a Hungarian default have on the European Union and the euro? Hungary is not a particularly large economy and it is not part of the Eurozone. However, a default on its debt can prove a crippling blow to something more important than debt obligations themselves: confidence. A default from this economy could theoretically translate into losses for neighbor economies that have exposure to Hungary’s debt. Yet, the sting of actual losses is not even that important. For investors, trouble for this particular economy can easily be construed as regional problems (it isn’t difficult to convince the masses of this given the circumstances). With capital flowing away from Europe and into US, Asia and other liquid regions, the withdrawal of liquidity forces borrowing costs for other struggling EU nations (think Greece, Portugal, Spain, Ireland, Italy, etc) higher. That only further exacerbates the struggle these economies face in balancing deficit cuts and economic recovery. And, should the emergency credit line be put to the test, we would likely see that few have the means to lend and those that do would likely renege as they see the problem overwhelm the solution.

In the long-term, the EU’s solvency and unity are the primary concerns for the euro. However, this is a matter that could take considerable time to unfold. In the meantime, risk appetite will treat the euro as if it were at the top of the risk spectrum – the most sensitive to risk aversion at least. As for scheduled event risk, the ECB rate decision is top concern. There is no chance of a rate hike according to the markets and economists (overnight index swaps only see a total of 30 bps over the next 12 months). On the other hand, it is highly likely that we will see reference in the statement that follows and Trichet’s commentary to the EU’s financial and economic uncertainties.

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