3 Takeaways From Euro Weakness

Includes: FXE, UDN, UUP
by: Kathy Lien

With Spanish and Italian bond yields on the rise and equities falling sharply in the U.S. and Europe, it is no surprise to see the euro continue to weaken against the U.S. dollar. The level of fear in the financial market is extremely high and the sell-off in the EUR/USD tells us that investors are worried about further trouble ahead. The persistent weakness in the EUR/USD along with the rise in bond yields and slide in stocks provides at least 3 interesting takeaways:

#1 - First and foremost regardless of the denials by Spanish lawmakers, investors have already begun to price in a full scale bailout. Over the past year and a half, we have seen the market turn a number of countries into panhandlers asking for help from the European Union. Borrowing costs in Spain have already reached unsustainable levels and the price action in the euro suggests that investors believe it should only be a matter of time before there is a need for a sovereign bailout. A number of developments could occur before Spain formally asks for help including a downgrade by Moody's or Standard & Poor's and the decision to hold an emergency EU Summit, all of which are near term negatives for the EUR/USD.

#2 - The second takeaway from the minor change in speculative positioning and the major decline in the euro is that speculators are not the only ones selling. We have heard a significant amount of interbank chatter on central banks diversifying out of euros and into other currencies, particularly the Swiss National Bank which is said to have been swapping their euros for Australian dollars. While this behavior isn't confirmed by the SNB, we wouldn't be surprised if they are selling euros especially if they are concerned about losing money on their massive euro holdings. The SNB's efforts to cap the Franc's rise against the euro led them to their accumulation of a massive amount of euros. The recent sell in EUR/USD will only require an even greater commitment to intervention and if the SNB wants to avoid losing even more money on their EUR/CHF positions, the smart thing to do would be to convert some of those euros into other currencies such as the British pound or Australian dollar.

#3 - Finally, the sell-off EUR/USD tells us that forex traders have cut their QE3 bets. Considering that the Federal Reserve won't make a decision about Quantitative Easing until September, the pressure on the euro makes stimulus from the European Central Bank before the Fed a more likely scenario. The German IFO report is due for release on Wednesday. Given the decline in manufacturing and service sector activity in Germany, there is a good chance businesses grew more pessimistic in the month of July.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.