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Euro on the Verge of Financial Panic but Risk Appetite Still Holding

Euro on the Verge of Financial Panic but Risk Appetite Still Holding

2011-05-14 07:01:00
John Kicklighter, Chief Currency Strategist
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Euro_on_the_Verge_of_Financial_Panic_but_Risk_Appetite_Still_Holding_body_Picture_4.png, Euro on the Verge of Financial Panic but Risk Appetite Still Holding

Euro on the Verge of Financial Panic but Risk Appetite Still Holding

Fundamental Forecast for the Euro: Bearish

If ever there were a good example of the equilibrium of risk / reward in the markets, it would be the euro. Even though the shared currency does not maintain the highest yield amongst its peers (the Australian and New Zealand dollars are still offering a better return); it nevertheless holds itself out to be as resilient as its more valuable counterparts. What makes this performance particularly remarkable though is that this inherent optimism is maintained despite the euro’s facing some of the worst fundamental risks of any of the majors markets. The financial troubles facing Greece and Portugal specifically present problems that run to the very core of euro and the European Monetary Union it represents. In the balance between the fear and greed that defines this (and every) market, there is clearly a dislocation – and it is primarily centered on the under-appreciation of present and growing risks. If we want to gauge when the euro will finally capitulate, our focus should be expectations for instability.

My general outlook for the euro has been a bearish one for some time; but that does not necessarily mean we should immediately trade that bias. There have been historically many periods when the investing masses have tolerated excessive risk or disregarded exceptional return to maintain a comfortable trend. This seems to defy fundamental reason; but more accurately, it reflects the markets’ prejudices – and the market defines price. As for the financial troubles facing the Euro-region, the problems are well-known which may lead many to believe that they are fully priced in. Yet, the full potential fallout from a debt/currency crisis is unknown and the ECB’s effort to keep inflation under wraps has given short-term speculators a convenient distraction. Should we see the meeting of Eurogroup Finance Ministers over the first two days of the week come up short on a solution for Greece, Portugal and Ireland; it could further bring the region’s troubles into relief.

To understand the market impact from the event; we need to know what is at stake. At the forefront of the discussion, we have Greece which forced the region to the next leg of the financial devolution. Though officials will not to admit as much, it is not unlikely that the country indeed threatened its EU counterparts that it would withdrawal from the monetary restraints (which come along with the currency) unless further accommodation was made. Few other scenarios would encourage such a prompt and compliant vow to offer the member further aid (regardless of the European Commission’s updated forecast for Greece to post a wide-target missing, 9.5 percent debt to GDP ratio this year). However, accommodation for this already deeply indebted nation would certainly encourage Ireland and Portugal (who have recently seen political upheaval as citizens vote on anti-austerity beliefs) to demand the same. With more than 250 billion euros in aid already extended, further rounds of accommodation will only push us closer to the breaking point.

Will this particular meeting provide the shock that changes the balance in the market? The probability is not high. As we have seen with previous meetings with similar stakes, policy officials are adept at playing to funding and currency markets that preoccupied with passive returns with flimsy promises. With Germany refusing further amendment without equivalent guarantees of progress, it is even more unlikely that we will see purposeful improvement. That said, a rebound for the euro is a more likely scenario; but it will die out quickly as few are expecting a roaring recovery from the region’s troubles. The deciding factor may actually lie outside of the euro’s own fundamental influence. Should we see global risk appetite falter, traders will abandon the most overvalued and troubled assets – the euro among them. - JK

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