Euro To Fall Further On Deteriorating Outlook

Includes: FXE
by: Colin Lokey

As investors flooded into risk assets last Friday following the EU Summit, Barclays had the following to say about the prospects for the euro (CurrencyShares Euro Trust ETF: FXE):

"...the news overnight is not a game changer for the EUR...the agreement on how to implement the conclusions reached is not as strong as headlines initially a result we expect investors to remain cautious. This will keep the risk premium on the EUR elevated... We remain bearish on EURUSD, expecting it to grind slowly down to 1.15 over the next 12 months"

Six days later and that prediction appears quite prescient as the EUR/USD has fallen below 1.24 from around 1.27 after the EU Summit agreement. For the most part, sentiment has headed south since the post-summit euphoria as euro bulls grapple with the reality that direct capital injections into Spanish banks are unlikely in the near term, as are rescue vehicle-funded sovereign debt purchases.

This deteriorating outlook, as well as renewed pressure on Spanish and Italian debt, has rattled sentiment over the past two days, contributing to a decline in the EUR/USD pair from an intraday high of 1.2628 on Tuesday to as low as 1.236 Thursday. Additionally, the 3-month euro-dollar basis swap traded as wide as 69 basis points Thursday, it's most expensive level since March.

The catalyst for the selling of the pair Thursday was a downbeat take on the prospects for the Eurozone economy from ECB president Mario Draghi. After announcing a 25 basis point rate cut, Draghi noted that:

"The risks surrounding the economic outlook for the euro area continue to be on the downside,"..."Beyond the short term, we expect the euro area economy to recover gradually, although with momentum dampened by a number of factors. In particular, tensions in some euro area sovereign debt markets and their impact on credit conditions."

Additionally, Draghi reminded the market that the central bank's bond buying program was temporary, a statement that served to further dampen the hopes of those hoping the ECB would wade back into the sovereign debt market to stem the rise in Italy and Spain's borrowing costs.

None of this bodes well for the euro. As long as the situation in the Eurozone remains precarious, the common currency will continue to drift lower, as investors abandon ship for safe havens. Bloomberg noted Thursday that according to Bank of America, it's not just the fundamental outlook for the eurozone that's deteriorating, the technicals for the currency are breaking down as well. The break below 1.2409 Thursday marks the renewal of a bearish pattern, according to the bank's head of foreign exchange technical strategy.

Another concern is that many analysts (including those at Barclays) expected a 50 basis point cut from the ECB. Given the negative prospects for the region, it's not unreasonable to suggest that another 25 basis point cut could be in the cards, something that the currency may not have priced in as of yet. Indeed, some analysts viewed the ECB's surprise move to cut it's deposit rate to zero as indicative of the central bank's intention to ease more.

Regardless of predictions about the ECB's next move or speculation about what the charts seem to be telling us, the best argument for continued and persistent weakness in the euro is that derived from common sense. The eurozone is struggling in the depths of a political crisis, a debt crisis, and a banking crisis and the ECB's balance sheet has expanded to 3.1 trillion euros, nearly half of which is composed of bank loans. Although an upside surprise from the U.S. Bureau of Labor Statistic's non-farm payrolls number could give risk assets a boost Friday, the prudent and the patient should position for continued weakness in the euro through the remainder of the year.

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