Euro Bounce: Now What?

Currency in Crisis

A January 9th post Timing and Magnitude of Euro Bounce warned that the euro was within about 1% of what we expected to be a near-term bottom before staging a recovery. The euro declined almost another half a cent after our note and subsequently rallied 4 cents at today's high.

We suggested that the correction could carry the euro to $1.2950-$1.3050. This has been reached this week. It is therefore worthwhile to look at our arguments and assess the state and outlook for the euro's correction. We argued that the main weights on the euro were the roll-over risk and risk of sovereign downgrades.

We countered that the roll-over risk was minimal in January as the maturing bonds and coupon payments largely offset the expected new supply and that the downgrades were largely discounted.

We also argued that the market, where sentiment and positioning were extreme, was overlooking two supportive factors. First that the 3-year LTRO was more significant than many understood and second, citing the EU rejection of Belgium's budget, we argued there were indeed concrete steps toward constructing the scaffolding for a fiscal union.

Lastly, we suggested that much of the stronger US economic data had been discounted and the market positioning left it vulnerable to less favorable news. This extended to the conclusion of the FOMC meeting tomorrow, where we had recognized the likelihood that the FOMC forecasts will suggest no rate hike into 2014 from mid-2013 currently.

While our arguments appear valid at the time and in hindsight, we are concerned that a good part of the euro's correction is now past; that the news stream for Europe is going to disintegrate again. The risk of a hard default in Greece appears to be rising, as one should expect the stakes are so high and the brinkmanship tactics are used on both sides. Portugal, which is now rated as below investment grade by all three major rating firms, has come under increased pressure. The 5-year CDS is at record highs today as Portugal may not only need a second aid package, but debt restructuring to boot.

We also are concerned that the balance between European bond maturities and coupons vs new supply turns against the euro area in February. In addition, the market appears to have generally taken on board the shift in the Fed's communication style and the dovish thrust of the Fed funds forecasts may be blunted by the FOMC statement itself which is likely to recognize the recent improvement in labor and housing data (and the overall economy more generally).

As month end approaches, there is scope for addition downgrades from Fitch and there is some risk of Moody's action on France's outlook. While the markets took the S&P move in stride, as we had anticipated, additional downgrades may not as easily be absorbed.

The market also seems vulnerable to disappointment stemming from next week's EU heads of state summit and new debates over the ESM funding. The market's attention will also shift toward the ECB meeting on February 9th. Rate cut expectations have been dampened recently, but may rekindle as the date draws near.

In our earlier note, we suggested that depending on how the correction unfolded there was scope toward $1.32. The euro's resilience and still extreme positioning, suggests this is still is a risk. A move above $1.3080 now would bring that into focus. A break of $1.29 would be the first sign that the correction has run its course.