Euro Extremely Prone to Collapse after EU Lackluster Rescue Effort

Fundamental Forecast for the Euro: Bearish

• The market scoffs at the ECB’s rate cut, liquidity program, reduced lending requirements
• EU Summit fails to provide solid foundation for rescue, basic clarity on overall effort
• The dollar looks for breakout, momentum after its tenuous congestion

Given the health of the financial backdrop, the pull in fundamental trends and the lackluster showing from European policy official last week; the euro is highly susceptible to an aggressive sell off. However, that does not guarantee the market will move for the panicked selling / speculative short positioning that is implied by practical fundamental analysis. As it has been for some weeks now, the complicating factor for trading the euro is the liberal use of stimulus and the market’s expectations for further intervention. However, after 19 months of failed crisis fight; patience and optimism is wearing dangerously thin.

Heading into the new trading week, our immediate concern should be the dawning of reality for the masses as they work through the implications of last week’s ECB and EU policy decisions. The market has been well conditioned to expect moral hazard in bailout / rescue efforts whenever the region’s market comes close to the brink of a full-blown catastrophe. What we are measuring now is how long false optimism for an impotent rescue plan lasts. Having already seen four previous programs fail to stem the tides; you would expect the speculators to snap to reality much more quickly than they have in the past. Yet, we should never underestimate the intoxicating influence of hope.

Euro traders were left somewhat confused by the full implications of the efforts announced at the end of this past week. However, after a weekend to fully review the terms that were given; it won’t be hard for skeptics to convince the holdouts that the outlook has not improved. From the EU Summit, the most clear-cut proposal was a 200 billion euro increase in the bailout funding that would direct central bank capital to the IMF to be used to recycle the capital back in the EU. Convoluted. Aside from that, the reinforcement of budget caps and plans (but no details) for automatic mechanisms from each member to cut spending and boost tax revenue should deficits breach 3 percent prevent future troubles (if a detailed plan is ever provided). Yet, it doesn’t solve current issues. Nor does the accelerated adoption of the permanent 500 billion euro cap ESM program by July 2012 (running concurrent with the EFSF – though it isn’t clear if they’re cumulative totals would surpass 500 billion). Promises of rescue matter little however unless the capital is actually lent out when it’s needed. And, given the recent reticence with Greece and Italy; further complications could prove the EU’s will flimsy.

We shouldn’t expect anything more from the EU until the March Summit (unless the region is falling apart). That leaves fading hope with the ECB. The central bank lowered the benchmark rate to 1.00 percent, announced a 36-month liquidity line and reduced the reserve ratio and banks collateral requirements for loans; but that does boost European financial institutions’ confidence in each other. If the European markets slide, expectations will lead participants to place their hopes in a broad bond purchasing program much like the Fed’s QE2.

What will guide sentiment in the euro and confidence in the recent policy initiatives is the health of the European financial market. Despite all the promises that have been made this past week; conditions continue to deteriorate. At the sovereign level, the ECB had to reportedly buy Italian, Spanish and Portuguese bonds Friday as yields were swelling once again. In the coming week, we have bond sales for Italy, France, Spain, Greece, Belgium, German and the EFSF scheduled. These offer a clear read on confidence. More critical to systemic market health is the functioning of the bank-level credit conditions. The rates that euro banks charge each other, demand for US dollars and deposits held with the ECB all continue to rise. Any hope of regaining market confidence requires a reversal here. – JK

--- Written by: John Kicklighter, Senior Currency Strategist for DailyFX.com

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