Fundamental Forecast for Euro: Bearish

Currency traders sent the euro sharply lower against the US dollar mere days after it surged to 9-month highs—strongly suggesting that the EURUSD may have set an important top through the previous week of trade. Renewed fear over Euro Zone member fiscal solvency was ostensibly the justification for the declines, but we would argue that the pullbacks were mostly a function of major sentiment extremes. That said, a surge in the spread between Irish government bond yields and benchmark German Bunds warns that Euro Zone unity is once again at risk. The euro could continue to weaken as traders shed EURUSD-long positioning amidst uncertainty surrounding the monetary union.

A handful of economic data releases could force modest intraday volatility across EUR pairs, but developments surrounding Irish fiscal health and government bond markets will likely dominate fundamental trends through short-term trade. The surge in the spread between Irish and German government bond yields is strongly reminiscent of the market turmoil seen through the Greek debt saga. Though the Irish government’s funding needs are likely less pressing than bond yields would suggest, one gets the sense that we are seeing a repeat of the events that led to the Greek bailout in May. The euro weakened substantially through that episode, and a continuation in tensions would likely force further EURUSD losses.

According to recent CFTC Commitment of Traders data, Non-Commercial traders remained near their most net-long EURUSD since the pair topped in late 2009. We have long argued that important sentiment extremes warned of EURUSD reversal. Such calls were clearly premature, but we now see legitimate risk of further corrections as speculators close their long positions. Fresh fears over Euro Zone member fiscal solvency may be the spark that starts a much larger sell-off. Indeed, we see risk that the US dollar may recover from recent bearish sentiment extremes against other major counterparts for much the same reason.

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