Fundamental Forecast for Euro: Bearish

- Spain passes a critical auction and the ECB injects liquidity, conditions still tense
- German unemployment levels fall for a 12th month
- Will EURUSD’s advance run out of steam, or is this a genuine reversal?

Has fundamental reasoning broken down for the euro? It wouldn’t be the first time if it were to happen; and it certainly wouldn’t be the last. This past week, the euro sparked an aggressive rally through the beginning of Thursday’s session that ran in direct contrast to the risk aversion that the capital markets (equities, commodities, bonds) were reflecting. The breakdown is in the euro’s position as a risky currency over the first half of this year. While some currencies are considered risky currencies because of the excessive levels of capital built behind them in an effort to earning high yields; other currencies maintain a direct, positive correlation to investor sentiment because they are fundamentally and speculatively risky. This is the case with the euro. A future of weak economic growth (with a few EU members facing a second recession), interest rate potential set to the distant future and the constant threat of a financial crisis plagues the shared currency. So, how long can the euro advance – especially when sentiment itself is tumbling?

The primary concern for the euro (and global sentiment) this past week was the success of a key bond auction and the expiration of the ECB’s 12-month Long-Term Refinancing Operation. Both of these events would occur without a crisis; but that does not mean that they were positive developments. On the contrary, Spain’s 3.5 billion euro auction drew weak demand (1.7 times the offer) and a higher yield (cost for the government). Sovereign efforts to raise capital will be an ongoing concern for the Euro-area. As of now, there are only two auctions planned by Germany and Austria; but neither is considered to be in exceptional financial distress. What traders are really concerned about is the ability of PIIGS and periphery European countries’ ability to access to the markets. A short-notice auction (Spain has to raise 24 billion euros this month) or an event that will make such an operation inevitably more expensive (a downgrade) will once again put the single currency back under bearish control.

Another sustained concern is the health of banks and lending institutions in the region. Relief that the region survived the expiration of the 442 billion 12-month lending facility this past week will quickly wear off. Traders will have to reconcile the fact that firms still asked for 243 billion euros in three-month and six-day loans. That is not a sign of a healthy market. On that note, we will monitor the ECB’s follow up call on its weekly refinancing operation and for any unexpected developments involving the health of particular economies’ banking systems (trouble is inevitable given enough time). For a scheduled take on the system, we will also watch the ECB rate decision. There will be no change to the benchmark lending rate; but changes to facilities, comments on the health of the region and plans for further purchases of sovereign government debt are all possible.

Risk appetite and financial uncertainty are the keys to the euro’s dominant trend; but short-term volatility could very well be a factor of scheduled event risk. That being said, the docket is relatively light over the coming week. Potential top releases in Euro Zone GDP and German CPI are diminished by the fact that they are revision numbers. Instead, we will have to garner an assessment of the regions underlying health. German factory orders and production activity, along with Eurozone investor sentiment and retail sales will give a broad coverage of all the major players in the economy.

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