Fundamental Forecast for the Euro: Bearish

A dismal week for the Dow Jones Industrial Average and broader risky assets should have sunk the risk-sensitive euro against the US dollar, but late-week news that the European Central Bank could start buying Italian and Spanish bonds left the EURUSD roughly unchanged.

Euro zone fiscal tensions were once again laid bare as the spread between Italian and German bond yields grew to its widest in 15 years. We have said time and time again: the euro zone does not have the capital to bail out a country the size of Italy and further bond stresses could truly shake the foundation of the monetary union.

Markets seemed assuaged by announcements that Italy would speed up austerity measures and produce a balanced budget a year ahead of schedule. Analysts and traders widely believe that this was done in order to secure the European Central Bank’s support in international bond markets. Indeed, some speculate that the ECB could purchase Italian bonds as soon as next week to stem recent sell-offs. Yet with total government debt of approximately 120 percent of GDP, it is hardly a guarantee that ECB support can ward off further Italian fiscal stress.

Market sentiment seems to be at a major inflection point with euro zone fiscal stresses and the European currency itself. We have frequently said that fiscal issues in Greece, Ireland, and Portugal mattered less onto themselves and more as contagion risks to the EMU core. Italy and Spain are the euro zone’s third and fourth-largest economies, and current bailout facilities are not large enough to bail out either government (and especially not both). Sudden financial market pessimism and the S&P 500’s worst week-over-week performance since the financial crisis warns that the week ahead could expose further stresses.

An early-week US Federal Open Market Committee interest rate decision could prove pivotal to broader market moves and, by extension, the Euro/US Dollar. We could be at a real turning point as far as Italian and Spanish bonds are concerned. US Treasury bonds continue to soar (yields tumble) on clear financial risk aversion, and continued contagion warns of further crisis.

It is surprising to note the EURUSD’s relative resilience in the face of recent troubles. Yet one has to wonder how long it can withstand market pressures—especially as the French CAC40 index posted a record 10 consecutive days of decline.

The pressure is on, and it is shaping up to be a make-or-break week across financial markets. How the US Dollar and broader major currencies react to a highly-anticipated US FOMC rate decision could set the tone. If we see disappointment, watch for continued market turmoil and strong potential for a broader dollar reversal.

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