Euro_Rally_Looks_to_Portugal_Bailout_Talks_for_Added_Fuel_body_tof_04082011__eur.png, Euro Rally Looks to Portugal Bailout Talks for Added Fuel

Fundamental Forecast for the Euro: Neutral

The Euro crossed an important threshold last week, violating the series of lower major tops and bottoms – the definition of a down trend – established from July 2008 when the currency set a record high above 1.60 to the US Dollar. This makes for a material change in positioning, shifting the bias in favor of the bulls on a long-term, structural basis. All of the elements for continued gains are seemingly in place: the European Central Bank has started to remove monetary stimulus, raising rates by 25bps last week; meanwhile, Portugal has finally taken the plunge to apply for a bailout to squash its debt crisis and EU officials have pledged to complete an 80 billion euro aid package by mid-May. Still, the specter of doubt continues to hang over the single currency and near-term gains may yet give way to a dramatic selloff as a reappraisal of the risk factors lurking within the common market undo investors’ confidence.

First and foremost, there is Spain. So far, investors appear feel generally sanguine about the nation’s prospects despite painful ratings downgrades in its banking sector, with 5-year credit default swaps (a gauge of the likelihood of a default) dropping to the lowest in eight months last week. Meanwhile, 10-year yields have been trending lower since peaking in above 5.5 percent in December. Bailing out Spain – the Euro Zone’s fourth-largest economy – would surely prove beyond the scope of the EFSF fund, and its perceived ability to manage its obligations is the central gamble at the heart of EU policymakers’ lackadaisical approach to managing the crisis. Indeed, officials lapsed on a deadline to top up the near-term rescue mechanism having pledged to have an agreement in place by late March.

The markets’ willingness to give the EU the benefit of the doubt from here is linked directly to how the negotiation over Portugal’s bailout plays out over the weeks ahead. Officials from the regional bloc and the IMF will head to the country next week to begin discussions that will entail corralling the country’s disparate political parties into committing to an austerity program more severe than the one that brought the downfall of the government in March and set off early elections. This is no small feat, and it is far from guaranteed that the Portuguese opposition will be any more willing to accept fiscal retrenchment when the demands for it come from Brussels. If the EU proves as rigid as it did with Ireland when it refused to lower the country’s borrowing costs without an increase in the country’s corporate tax rate – the lynchpin of its economy that would allow it to eventually grow out of its debt problems – the availability of funds in the EFSF for Portugal will prove moot as the country begins to wonder (no doubt amid massive domestic unrest) whether it really needs to put up with the eurocrats’ iron fist.

On balance, this makes for a deeply unstable outlook for the Euro over the weeks ahead. A robust rate hike outlook – with another 25bps increase seen as certain in May – is likely to keep the currency moving higher for exactly as long as a chance of accommodation in Portugal remains alive. Any headlines to the contrary, especially by way of protests or (worse yet) the emergence of EU secessionists as a key political force ahead of elections in June, would force a reappraisal of just how stable the Euro house of cards really is.