Fundamental Forecast for the Euro: Neutral

The euro was far and away the worst-performing currency on the week, rocked by a Portuguese credit rating downgrade and a noteworthy deterioration in euro zone bond spreads. The past week proved that a temporary fix for Greece is far from enough to solve the currency union’s crises. It will nonetheless be critical to watch whether key euro group meetings and key economic event risk will be enough to break the Euro/US Dollar below key congestion levels and force further losses in the week ahead.

Moody’s credit rating agency sent shockwaves through European debt markets as it downgraded Portuguese bonds to ‘Junk’ status, prompting similarly aggressive reactions out of regional policymakers and underlining stresses in the EMU. The controversial move came as Moody’s claimed that any future sovereign bailouts would likely require involuntary private sector participation. In other words, private bond holders would likely be forced to take losses on periphery debt—making outstanding bonds worth less on perceived credit risk. Portugal’s bond yields soared, and similar moves in Irish, Italian, Spanish, and Greek yields suggest bond traders are pricing in higher default risk across the board—undeniably bearish for the single currency.

Credit market activity puts focus squarely on an upcoming Eurogroup meeting starting Monday, and it will be important to watch any and all developments surrounding the makeup of the second Greek bailout as well as plans for similar episodes in the future. As part of the proposed Greek bailout package, European officials seemed likely to force private investors to roll over Greek bond holdings as they matured. Yet the S&P rating agency threw plans into doubt as they said they would rule any such action as a default. This leaves key questions on how officials will deal with the inevitable fiscal aid package and places doubt over the stability of the broader euro zone.

It has always been this author’s contention that Greece was not so significant onto itself but as a catalyst for broader contagion. In other words, the Greek economy is only the 13th largest within the euro zone and less than 10 percent the size of Germany. Yet stresses in Greece have led to similar attacks on other sovereign debt markets, and the EMU’s third and fourth-largest economies Italy and Spain have seen bond yields soar as traders price in a drop in creditworthiness. The spread between the Spanish 10-year bond yield and the benchmark German equivalent has quite recently soared to a fresh euro-era high, warning of spillovers in fiscal crises.

The key question is subsequently whether the euro zone can remain stable given such stresses, and indeed it will be important to watch rhetoric from the Eurogroup on its highly-anticipated meeting. Traders should otherwise watch upcoming German and euro zone Consumer Price Index inflation figures as well as a late-week European Central Bank Monthly report. Whether or not the single currency holds key support near the 1.4200 mark will likely depend on the coming week of key event risk.

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