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Euro to Face Fears of Contagion as Fitch Cuts Spain’s Credit Rating

Euro to Face Fears of Contagion as Fitch Cuts Spain’s Credit Rating

2010-05-28 21:14:00
David Song, Currency Strategist
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TOF-10-05-28-EURO

Fundamental Forecast for Euro: Neutral

- IMF Sees Spain Banking Sector “Under Pressures”
- ECB Says Bond Purchases Are “Temporary”
- Bundesbank President Says “Too Early” To Declare End To Financial Crisis

The Euro pared Friday’s rally as Fitch cut its AAA credit rating for Spain, and fears surrounding the European debt crisis could weigh on the single-currency over the following week as policy makers take unprecedented steps to stem the risks of contagion. At the same time, members of the European Central Bank have tried to talk down market speculation and said that its asset purchase program has not changed the Governing Council’s stance on monetary policy as the central bank reiterates that it will not be engaging in quantitative easing. Moreover, the ECB said that market developments will determine the timeframe for the government bond purchases as it aims to stabilize the financial markets, and acknowledged that the euro is trading within a normal range with the U.S. dollar, which should benefit the economy as it increases the competitiveness of European goods on a global scale.

As a result, Organization for Economic Cooperation and Development said that the Governing Council should maintain a loose policy stance and support the economy “until late 2010,” and encouraged the governments operating under the fixed-exchange rate system to take further steps to balance the imbalances between the countries. Meanwhile, China’s State Administration of Foreign Exchange voiced support for Europe and said “the euro zone will definitely overcome difficulty and safeguard the stable and healthy development of the financial markets,” and went onto say that the region will remain a key investment for the emerging economy as policy makers take the appropriate steps to contain the risks for contagion. At the same time, the Bundesbank expects Europe’s largest economy to grow “strongly” in the second-quarter as global trade picks up, and the improvement in the economic outlook paired with the rebound in global growth could support the euro over the near-term as fears surrounding the debt crisis tempers off.

Nevertheless, as the preliminary first-quarter GDP reading is expected to show the growth rate expanding 0.2% after unexpectedly holding flat during the last three-months of 2009, while the CPI estimate is projected to increase to an annualized pace of 1.7% in May, which would be the highest reading since November 2008. As growth and inflation improve, the central bank may show an increased willingness to normalize policy further this year, but the spillover effects of the financial crisis could weigh on the exchange rate over the near-term as the central bank remains dovish. - DS

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