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The euro recovered after falling to a 3-week low against the dollar as markets welcomed the results of Spain's bank stress tests, but investors remain cautious as the threat of a Spanish sovereign downgrade lingers.

Eurozone manufacturing data came in better-than-expected on Monday, also underpinning the shared currency, but euro's gains could be limited by uncertainty about when Spain would seek a bailout. Moreover, Moody's decision on Spain's sovereign rating is still due, and even a one-notch downgrade would push Spain's rating into junk status, mounting pressure on it to seek a bailout.

"The Spanish bank stress test results reported after European close on Friday came in-line with the original estimates rather than opening up new downside", says TD Securities. "Combined with suggestions Spain may be trying to forestall any imminent Moody's rating decision, and hope that between now and Monday's Eurogroup meeting, Spain will request a bailout, European optimism has returned for the time being".

During the American session, the focus is likely to remain on the U.S. ISM manufacturing PMI, with the index expected to print sub-50 for the fourth month in a row. Key data week ahead, with non-farm payrolls and the FOMC Minutes both released this week and the ECB and BoE also set to meet.

Euro off 3-week low but downside risks persist

The euro fell to a 3-week low of 1.2803 to start the week, but managed to bounce above 1.2900 during the European session. However, gains are likely to be limited as uncertainty persists in the euro zone, with Moody's decision looming and the Troika returning to Athens.

Yet the future of the EUR/USD is not that clear, as the U.S. has its own issues. On one hand, in an attempt to boost the sluggish economy, the Fed embarked in an aggressive asset-buying program, known as quantitative easing, while on the other hand, presidential elections and the fiscal cliff could weigh on the USD. With EUR/USD having retreated from a double-top of 1.3170 and finding support at 1.2800, in the short-term, the EUR/USD appears to be more of a range trade.

In a longer-term, the TD Securities team remains bearish. "Support just above 1.2800 was the overnight floor though, and the recent bid for risk currencies has seen the single currency rise more than a big figure higher," said the TD Securities team. "All that, however, remains roughly within recent ranges. Taking a step back, we think this bear trend (since mid Sept) still has further legs. Core eurozone-U.S. 2-year spreads being more consistent with EURUSD sub-1.25 is one factor that keeps us confidently bearish".

Meanwhile, BBH analysts note that the technical tone is weak. "The attempt to rally in the second half of last week failed and the euro finished the week near the recent multi-week lows. The technical tone is poor, with momentum indicators pointing down. In the coming days, the 5-day moving average will most likely cross below the 20-day moving average, confirmed the downtrend", they explain. "A break now of the $1.2775-$1.2800 area signals another 1-2% decline. It requires a move above the $1.3000-50 area to signal a new leg higher, which we had previously thought possible".

However, Rabobank team notes that the Fed's accommodative policy "will likely insure that investors are quick to reverse USD longs suggesting that bouts of USD strength will provide good selling opportunities," they say. "Medium term we expect EUR/USD will push towards 1.35."

Source: Euro Recovers But Spain Worries Linger