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Euro Stability in the Face of Financial Trouble a Sign of Strength?

Euro Stability in the Face of Financial Trouble a Sign of Strength?

John Kicklighter, Chief Strategist
Euro_Stability_in_the_Face_of_Financial_Trouble_a_Sign_of_Strength_body_Picture_5.png, Euro Stability in the Face of Financial Trouble a Sign of Strength?

Euro Stability in the Face of Financial Trouble a Sign of Strength?

Fundamental Forecast for Euro: Neutral

The euro has suffered through more than its fair share of fundamental threats through the past weeks; and yet, the currency has managed to maintain an impressive strength. Can this benchmark currency exploit its fundamental buoyancy and drive EURUSD above 1.3200 this week? That depends on the backdrop for broad investment sentiment as well as a few key pieces of event risk.

As the saying goes, a rising tide lifts all boats. For the euro, a tepid economy, constant heaves threatening a possible return to financial crisis and a growing social discontent have all been played down due to the optimism across the global capital markets. Optimism tied to stimulus from the European Central Bank (ECB) and other major central banks has seen volatility measures sink as equity markets rise. In a global economy and market where capital easily moves across borders, an appetite for yield amongst US and Japanese investors backed by domestic efforts readily spills over to a market as large as the Eurozone.

With the S&P 500 guiding US capital markets to record highs, a sense of global optimism bolsters the appeal of higher rates of return in European assets while simultaneously distracting from the risk that justify those yields. The currency’s sensitivity to risk is easily read when we compare the regional Eurostoxx 50 Index to pairs like EURUSD, EURJPY and EURGBP. While to this point, speculative appetite has played its role as an enduring support for the euro, the complacency it has encouraged in the face of regular waves of fundamental trouble has created a greater level of dependency on constant optimism. That means, if equities were to abandon the stimulus-supported climb to reconsider domestic conditions, the euro would be exceptional prone to a tumble.

As we keep a constant vigilance for inclement shifts in risk trends, the euro will test its mettle against a round of important event risk in the week ahead. The most immediate concern is the political situation in Portugal. President Anibal Cavaco Silva set a Sunday deadline for the coalition parties and main opposition Socialists to reach an agreement – a “National Salvation Pact” – as to how the country will meet the terms of its bailout program. However, after six days of fruitless negotiations, Socialist Party leader Antonio Jose Seguro announced that talks had fallen apart. The point of contention was the plan to carry out €4.7 billion in further spending cuts necessary to unlock the penultimate trance of support.

What makes Portugal’s situation so dangerous is that the variable outcomes are not clearly defined. The President rejected a previous budget agreement that was reached after the Prime Minister offered a resigning Paulo Portas a position as his deputy and gave him charge of economic policy. It is unclear whether this can sabotage the next round of support from the Troika, jeopardize next year’s exit from stimulus and damage market confidence.

As the week wears on, the economic clouds don’t seem to clear. Back to Portugal, the Bank of Portugal’s update on bank lending and the government’s year-to-date budget report will be reviewed with greater scrutiny. Meanwhile, another well-known bailout recipient – Greece – will draw debate from European officials. The country passed an unpopular bill last week that pushed through public reforms that include 25,000 of possible public job losses aimed at securing the next €2.5 billion in aid. Was it enough to unlock the support? We may find out.

Moving from individual hot spots to general conditions, the European Central Bank will release to reports that care substantial heft: a Euro-Area Monetary Development and regional Bank Lending Survey. Both are critical areas of fundamental stability for the currency, but even a disappointing outlook would likely be disarmed by language or by simply ignoring pressing issues. These should, therefore, not be considered likely sparks for a serious euro impact – either bullish or bearish.

On the other hand, ‘standard’ event risk may create waves in the FX market. Top data release is Wednesday’s advanced reading of the July Eurozone PMI survey. This is historically a good and timely gauge for the closely watched quarterly GDP figures. With the longer-term government numbers due in a few weeks, Portugal promising it could show 2Q growth and the will for austerity fading across Europe; this data will touch upon the region’s greatest fundamental threat. - JK

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