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Euro: Will a Delayed Fear of Collapse Allow for a Recovery?

Euro: Will a Delayed Fear of Collapse Allow for a Recovery?

2010-05-22 02:49:00
John Kicklighter, Chief Currency Strategist

When evaluating the euro, the first concern must be the rate of infection and symptoms of the Greek-borne financial crisis. At some point over the past month, fears that Greece could default and other European Union members were close behind evolved from being the source of the broader market’s fears to the object of uncertainty. Risk aversion eventually built up so much momentum, that it was self-sustaining. With investors looking to reduce their exposure to risky positions, the focus would naturally turn to the potential sovereign default for one of the Euro Zone’s most profligate members and the potential shock waves that would entail for the region. Without the market’s confidence, there would be no demand for the high risk and long-term commitment in purchases government debt from Greece , Portugal, Spain, Ireland and other financially-troubled members which would only exacerbate fiscal troubles and hasten a default. This is why the ECB took up the charge of buying government bonds; but can the central bank prop the entire region up itself? No. The promise of a 750 billion euro rescue package and a creditor of last resort is simply a means to buy time. Should a fluctuation in sentiment drive yields up on government debt auctions, the ECB will have to take up more of the burden and nations will be forced to ask for monetary assistance.

The other concern going forward comes from the ability of the individual EU members to accept the costs of a rescue. This does not refer to the interest that has to be paid on loans but rather the social unrest and economic pinch that results from severe spending cuts and tax hikes. The economic repercussions may take a while to fully realize; and on that account the market likely has some time. However, average citizens are already protesting the announcement of austerity cuts by leaders and pressure will only increase as conditions seem to worsen. This balance between approved cuts and the level of objection from the populace will likely stand as the front line for this ever-evolving situation next week.

Though the focus may be on investor sentiment’s impact on the euro, it is important not to forget the currency’s own fundamental standing. Should risk appetite extend its recovery, the masses will have to evaluate whether this necessarily boosts the appeal of a long euro position. For interest rates, with the ECB engaged in a quasi-quantitative easing effort, there is little scope for higher yields any time this year. In fact, the 12-month forecast for interest rates stands at a sparse 27 basis points. Furthermore, growth (another view on return) is undermined by the fact that so many economies have to remove economic stimulus and engage in austerity cuts and tax hikes. Under this policy, growth will at most stagnant for the regional economy.  - JK

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