Eurozone: Don’t Believe the Hype

10/10/2011 10:10 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist, FOREX.com

Without a concrete plan to recapitalize debt-laded Eurozone banks, look to sell the euro—and risk assets in general—on strength in the week ahead.

After a terrible start to last week, market sentiment rebounded sharply on word that European Union (EU) leaders were working on a plan to recapitalize Eurozone banks to weather credit losses on peripheral EU debt. The key here is that they’re still discussing how to go about it and have no concrete plan yet.

It’s hoped that the weekend meeting between German Chancellor Merkel and French President Sarkozy would yield a workable blueprint, but doubts over financial-sector stability are likely to persist, especially after Friday’s rating downgrades to Spain and Italy. (This weekend also likely sees the finalized break-up of French/Belgian bank Dexia, the first major casualty of the debt crisis.)

Merkel backed off earlier comments that national governments would provide recapitalization funds and most recently indicated that banks should seek to raise private capital first. Failing that (and only EU core banks are likely able to raise funds in markets), it would be up to national governments to provide capital.

Merkel appears insistent that the European Financial Stability Facility (EFSF) should only be used as a last resort. That brings up several problems.

National governments already struggling under excessive debt burdens would be forced to borrow even more to bail out their banks. France, in particular, is concerned it may lose its AAA credit rating if it’s compelled to borrow more to fund French banks. Peripheral governments may find it next to impossible to access markets in this effort. Which leaves the EFSF as the final source of funding, but the facility is currently too small, and plans to leverage it appear to be failing.

It also raises the question of whether an EU-wide bank recapitalization makes a sovereign default more likely, as banks would theoretically be more able to withstand losses.

That brings us back to the primary fear, namely, that an uncontrolled Greek default could trigger a domino effect, potentially triggering a global financial crisis. Against this backdrop, we continue to look for opportunities to sell EUR on strength as well as risk assets in general.

EUR/USD price action for the week (a doji on weekly candlesticks) suggests immediate downside potential is waning and a period of consolidation is likely to develop. There are many EU meetings to come in the weeks ahead, and markets seem inclined to give EU leaders the benefit of the doubt until concrete proposals are fielded.

The Oct. 17-18 EU summit is expected to see the bank recapitalization framework finalized, but discussions in advance should continue to provide market-moving headlines. Also, this week will see Slovakia’s vote to ratify the enlarged EFSF agreed to back in July; the vote is expected to pass, though the government there may fold.

We think prospects for bank recapitalization should prevent EUR from weakening directly further, but that longer-term prospects should also contain rebounds. This suggests trading a range on the long side from between 1.31/1.32 and from the short side between 1.35/1.36 for the next few weeks, followed by a break to the downside.

NEXT: Italy and Spain Downgraded; Latest US Jobs Data

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Italy and Spain Get Downgraded

Following the close of markets in Europe on Friday, Fitch ratings agency announced credit downgrades to Italy (one notch from AA- to A+) and Spain (two notches from AA+ to AA-). Both countries’ outlooks remain negative, meaning further downgrades are possible.

Fitch kept Portugal at BBB- while it completes its review in the 4Q, potentially seeing a cut to junk status. The timing of the move was a surprise, but downgrades are not unexpected these days and markets still think credit rating agencies are behind the curve. But the actions reinforce the view that Eurozone problems continue to have global repercussions, as the euro, stocks, and commodities all reversed post-NFP gains, and the US dollar rebounded.

European markets did not have the chance to react to the downgrades, and there is some potential for another selloff to start next week. But with a weekend to digest the downgrades, and depending on the outcome of the Merkel/Sarkozy meeting on Sunday, we think global stocks and FX may see further consolidation. We will be closely watching Asian markets on Monday’s open, as they have been increasingly among the most panicky regions in the selloff of the last few months.

US Jobs Data Obscures Future Weakness

Markets were positively surprised by better-then-expected job growth in the US in September, but we would resist the urge to celebrate. The pace of job creation remains woefully inadequate to improve the US employment outlook.

More ominously, a pair of leading indicators suggests labor markets may actually begin to deteriorate in the months ahead. The employment index of the September ISM non-manufacturing index fell to 48.7, below the critical 50 expansion/contraction line. A move below the 50 level is typically associated with monthly job losses, indicating a potential negative number for the Oct. jobs report.

Also, the September Challenger survey of job cut announcements surged to 212% year over year, led by cuts at the US’ largest bank and by the US military. While military layoffs don’t reflect economic weakness, but rather budget cuts, it does add to further headwinds for job seekers.

While the September US jobs data lessen the potential for an imminent double-dip recession in the US, and are thus good for risk sentiment, the writing on the wall suggests serious risks remain to the near-term US outlook. The data reinforces our view that we may be entering a period of consolidation ahead and that risk assets may be worth a buy on dips and a sell on rallies.

By Brian Dolan, chief currency strategist, FOREX.com

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