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4 New Hurdles Threatening the Euro

4 New Hurdles Threatening the Euro

Kathy Lien, Technical Strategist

Following this past weekend’s G20 meeting and the US Presidents Day holiday, economic and political happenings in Europe and globally are combining to put renewed downward pressure on the euro.

Have the Euro's Troubles Returned?

With U.S. markets closed Monday in observation of the Presidents Day holiday, lighter volume is expected across the FX markets. The G20's decision to spare Japan from being singled out this past weekend is the top news story, as most of the currency language in the G20 communiqué was left unchanged. It is no surprise that the Japanese yen(JPY) is trading lower, as only two new sentences in regards to currencies appeared in the statement, which said, "We will refrain from competitive devaluation. We will not target our exchange rates for competitive purposes."

It was a close call for Japan, but now that the G20 meeting is over, the great yen short can resume. The next catalyst for yen weakness will be the nomination of a new Bank of Japan (BoJ) Governor, who will undoubtedly reaffirm plans to aggressively ease monetary policy. However, the euro could challenge the yen for the limelight this week as investors look to economic data and the European Commission's forecasts for clues on whether the 5% decline in stocks and sharp contraction in Q4 gross domestic product (GDP) growth means that euro's problems have returned.

More: See the complete Economic Calendar

European Commission's Growth and Deficit Forecasts Pose Risk to Euro

While investors were focused on policymaker comments about the euro last week, one of the most important comments came from the head of European Sovereign Ratings at S&P. Moritz Kraemer warned that Spain, France, Italy, and Portugal are at risk of being downgraded this year. If this week's economic reports and European Commission growth forecasts suggest that this risk has increased, then the euro could be in big trouble.

The decline in Eurozone GDP growth in the fourth quarter raised concerns that the complete lack of growth last year and the prospect of a flat first quarter will make budget deficits in the region even more unsustainable.

Germany has been carrying the Eurozone on its shoulders, and this week, we learn whether that continues to be the case when German IFO and PMI reports are released. If economic activity in Germany continues to surprise to the upside, the euro could find support, but if there are any downside surprises, the currency could tumble quickly. However, based on other economic indicators, such as factory orders and industrial production, Germany has had a steady start to the year. The Bundesbank also said that the German economy will return to growth in the first quarter.

Still, the European Commission's growth, unemployment, and deficit forecasts will be more important. While it is possible that the Commission will look beyond the contraction last year and focus on the signs of growth in the coming year, there could still be concerns about deficits and the currency.

Aside from the potential changes to growth estimates, we will also be looking to see if budget deficit forecasts are increased. If Spain's budget deficit is expected to exceed 8%, it could also raise the risk for a downgrade to the Eurozone's fourth-largest economy. If the forecasts remain largely unchanged, however, it could help the euro.

European Central Bank (ECB) President Mario Draghi will also be speaking before the European Parliament this week, but we don't expect him to change his view that the euro is near its long-term average.

Uncertainty Swirls Regarding Italian Elections

Elections in Italy could also pose a big problem for the euro over the coming weeks. The elections are being held on February 24 and 25, and between current Prime Minister MarioMonti calling his predecessor SilvioBerlusconi a buffoon and Berlusconi slurring in a speech, this will be an interesting one.

The leader of Italy's center left party, PierLuigiBersani, is running neck and neck with former Prime Minister Berlusconi. No one is expected to win a majority, and right now, it appears that Bersani is leading slightly in the polls. If he wins, he will most likely form a coalition government with Mario Monti's centrists. This is probably the best-case scenario since it would offer assurance of continued reform in Italy.

However, the elections are close and can still go either way. The worst case for investors and the euro would be a win by Berlusconi because he plans to abolish unpopular property taxes that acted as the cornerstone of Monti's austerity measures. A return to the free spending days of Berlusconi would be a big hit to confidence and would increase the risks of a downgrade for Italy. Along these lines, the uncertainty surrounding the Italian elections also poses a risk for the euro.

Is Fed Preparing to End Asset Purchases?

Finally, the Federal Reserve will be releasing the minutes from its last monetary policy meeting in January. If you recall, when the Fed released the minutes from its December meeting, the talk of phasing out asset purchases sent the dollar soaring.

The January Federal Open MarketCommittee (FOMC) statement made no mention of ending asset purchases this year, which was not surprising considering that only policy changes and not discussions make it to the final statement. However, talk of phasing out asset purchases could resurface this week, and if the central bank sounds serious about starting to unwind some of its emergency stimulus, the dollar could trade higher, putting downward pressure on the euro as a result.

Still, investors may not pay much attention to these discussions because they realize that at the end of the day, this is a view shared by a minority of FOMC members, and even if the idea gained traction, the Fed is still quite far from taking it seriously.

By Kathy Lien of BK Asset Management

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.