Caught in the sinking euro’s vortex

Posted on September 13, 2011

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A case for battening the hatches while the Greek tragedy plays itself out?

The European Central Bank. Notice a sculpture ...

The European Central Bank. (Image via Wikipedia)

Although the European single currency staged a mild recovery on Monday from its Friday fiasco, concerns remain that sentiment-driven trading is pulling other currencies down along with the euro. The Australian and Canadian dollars fell sharply, while emerging-market currencies also tumbled. The perceived structural weaknesses of the Eurozone are pushing central banks in other parts of the world to “protect” their currencies from consequent safe-haven strengthening. The Swiss National Bank has already taken steps in this direction and the Japanese regulator is expected to follow.

The European common currency remains weak amid fears that the Eurozone sovereign debt crisis is spiraling out of control. With fears growing about Greece’s ability to avoid a default, the mild pickup on Monday is unlikely to last, most analysts say. A sovereign default has the potential to send the dominoes tumbling in the financial sector as well. According to Bill O’Neill, Chief Investment Officer, EMEA, Merrill Lynch Wealth Management, the probability of a structural decline in the euro is increasing.

Uncertainty at the European Central Bank is adding to investor nervousness. Outgoing ECB President Jean-Claude Trichet‘s distinctly dovish stance, coupled with lower economic growth rate forecasts, are strengthening expectations of a rate cut. On the other hand, incoming ECB President Mario Draghi, viewed as a hawk, may spring some surprises when he takes over next month. The resignation of ECB Council Member Jurgen Stark – also a hawk who campaigned against issuing Eurobonds – appears to have distanced the German monetary machine from euro-management, adding to growing fears that the Eurozone is cracking under the strain of managing the peripheral nations’ sovereign profligacy issues.

Now add the US Federal Reserve into this mix, and the equation becomes even more difficult to read. A fresh salvo of quantitative easing from the Fed, if announced later this month, could increase consumer confidence in the US and help support the currency. Gain Capital’s Chief Economist, Kathleen Brooks, says she is worried about getting too bearish EURUSD. “This cross is likely to be a vicious see-saw in the next few months, with investors swinging between dollar negative sentiment – especially if there is QE3, and Eurozone fears… I don’t feel confident to go against the sell euro trend right now, pricing in rate cuts for the Eurozone may be a tad premature.”

O’Neill continues to remain cautious on the euro, and suggests hedging exposure, “as a likely rate cut by the ECB on top of increased ECB bond purchasing and ongoing political uncertainty, especially the balance between core and periphery, remain headwinds for the currency.” While faith has eroded in politicians’ ability to resolve the real issues that are creating volatility in currency valuations, analysts say, there seems to be a case for battening the hatches while the Greek tragedy plays itself out.

Intelligence on the euro and the Eurozone (Zawya.com):
Euro crisis draws G-7 fire as Merkel mulls Bank Aid
Stocks, euro plunge on Greek default, recession fears
Stark’s exit strikes shaky Eurozone at worst time

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