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2/14 – 12/18 Euro Outlook: Burdened By PIGS, and Its USD Connection

Summary

Euro Outlook: Bearish

-    Events: Mon: Euro-zone (EZ) Employment, Industrial Prod. m/m, Tues: German ZEW Sentiment, Wed: French Flash Mfg & Services PMI, German Flash Mfg & Services PMI, CPI, Core CPI, Fri, German PPI, Ifo Business Climate, Current Account

-    EUR’s negative correlation to the surging USD now dragging it down

-    Concern rising as Greece approaches default, Spain’s credit downgraded

-    ECB maintains its outlook for a moderate recovery in 2010

-    EURUSD’s technical outlook could support bearish momentum

Analysis

Moving like the opposite rider on a seesaw to the USD, the EUR’s strong negative correlation to the USD is arguably its biggest driver, and it suffered for it of late as much as it has benefitted over much of the past year. As the primary alternative to the US dollar, the EUR gained from intense demand for return and stability as the dollar swooned over the past year. As we’ve warned for many months,  however, when expectations for return in the United States improve and the irrational fear of dollar collapse fades; speculative capital flows will reverse. Simultaneously, there has been a fundamental weakening of the Euro Zone itself. The economic and interest rate outlook is weakening,  especially  with the instability that member default may  bring.

Initially, panic was sparked by Dubai World’s default/debt restructuring, but as we warned, this reminded markets to look for other at risk sovereign debt, which brought unwanted attention to the state of the PIGS (Portugal, Ireland/Italy, Greece, Spain). In rapid succession, we have seen Greece’s sovereign credit rating downgraded the outlook for Spain reduced to ‘negative,’ and suddenly the PIGS acronym has become as familiar as that of the BRICs. This in turn reminds us all of economic troubles that exist outside of Germany and France and the lack of flexibility that EZ-member policy makers have in stabilizing individual economies and markets. Unlike their US or UK counterparts, Finance Ministers cannot take on more debt than the Union allows, devalue their currency or adjust interest rates to help their economies along. This leaves restrictive parameters on nations that perhaps cannot recover naturally and must either seek bailouts (which will take many years to work off) or consider withdrawal from the regional collective. Either outcome could severely undermine the stability of the euro.

Also against the euro is a reduced view of its fundamental strength. Six to nine months ago, speculators expected the Euro Zone would be the first of the major economies to recover from the global recession and raise yields. However, it became increasingly clear that the EZ was seen falling further and further back in the growth race and the ECB maintained a solid front against raising interest rates until a recovery was certain. Today, growth is neither expected to match that of the US and Japan, nor is it certain there will be a return to hawkish policy by the middle of 2010, which is the Fed’s target.

Events

Along with USD events, so too may EUR events influence the EUR’s current decline. For growth, the December PMI indicators for Germany and the Euro Zone will offer key benchmarks for 4Q activity. For the ECB, regional inflation indicators will tell officials whether they should start responding with measured rate hikes to compliment other efforts to rein in policy. These indicators may offer short-term volatility but are likely to be overridden by the dollar and news about the potential debt crisis.

Disclosure: No  positions