Debt Downgrades Don’t Doom the Euro

01/16/2012 10:15 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist,

A rather muted reaction to new Euro debt downgrades leaves room for surprisingly bullish short-term EUR/USD prospects, especially with the growing potential for an upcoming QE3 program in the US.

The much-feared, yet equally anticipated EU sovereign credit rating downgrades have arrived. The winners were Germany, the Netherlands, Finland, and Luxembourg, which saw their AAA ratings sustained. The losers were Belgium, Austria, and France, which were cut one grade to AA+. The biggest losers were Italy, Spain, and Portugal, which were cut two grades to BBB+, three steps above junk.

The hope was that France could maintain its AAA rating, but a single-notch downgrade was not entirely unexpected. Still, it does jeopardize the AAA rating of the European Financial Stability Facility (EFSF) and the successor European Stability Mechanism (ESM), but we will need to see the ratings agencies make that determination later.

What we can expect next are ratings downgrades to the banks of the affected nations, which typically follows an adjustment to the sovereign rating.

While it’s still early to gauge the complete market fallout, what has impressed me so far is the relatively minor, calm reaction in key markets, suggesting that much of what has transpired was largely as expected, though perhaps a bit earlier than most thought.

EUR/USD declined sharply (around 1.5%), but ultimately maintained the week’s 1.2650-1.2850 consolidation range. Italian, Spanish, and French government bond yields initially rose, but later fell back to finish with only minor increases; all are below their one-month average yield, suggesting bond markets were expecting the downgrades.

Taken together, the market reaction so far suggests the potential for a rebound in EUR, especially in light of extreme short positioning, on a potential “sell the rumor, buy the fact” type reaction.

Option pricing indicates that bearish expectations now only slightly outweigh bullish views (one-month 25-Delta risk reversals, an indicator of directional sentiment, have recovered to -0.375 from an extreme low of around -3.0 in early November when the EUR began its descent).

Also, as the reality of the downgrades became more concrete on Friday, the weakness in EUR/USD only briefly exceeded lows made on rumors earlier in the week of an imminent downgrade, again suggesting that much of the news has been priced in.

To be sure, though, there is no reason we can’t see another leg down in EUR/USD. The weekly candlestick for EUR/USD looks to be forming an inverted hammer, frequently cited as a bullish reversal pattern, but on its face is a bearish candle requiring confirmation in the following week.

See related: How to Short the Euro with Less Risk

While the key 1.2600/1.2610 level holds on a daily closing basis (76.4% retracement of the 1.1880-1.4940 advance), we think there is scope for a correction higher, at least. A daily close below there would suggest further weakness to the low 1.20’s, and likely below for a full 100% retracement. Above, the 1.2870/1.2890 zone is the key resistance area where a move above would suggest potential to the 1.31/1.32 area in the short term.

NEXT: Important Shifts in EU/ECB Attitudes


Important Shifts in EU/ECB Attitudes

The credit rating downgrades did not occur in a vacuum, and there were other important developments this past week that also suggest some potential for a EUR respite. The ECB held rates steady and indicated it saw tentative signs of stabilization in the Eurozone downturn, though it’s also prepared to act if conditions deteriorate.

This suggests the ECB is in “wait-and-see” mode, eliminating imminent rate cuts as a EUR negative. Indeed, spreads between German/US two-year government yields have bottomed and moved slightly higher, suggesting EUR/USD should be above 1.2800.

In addition to the ECB’s long-term refinancing operation (LTRO), which has seen stresses in the European banking sector recede, the ECB is apparently considering accepting banks’ loan portfolios as eligible collateral for borrowing from the ECB, potentially making nearly EUR 1 trillion in additional ECB lending available. Plus, another LTRO is slated for February, reinforcing the idea that EU bank financing pressures will fade further.

Lastly, German Chancellor Merkel appears to have blinked, as she indicated this past week that Germany could increase its capital contribution to the International Monetary Fund (IMF) if others chose to follow suit. This movement should not be underestimated, as it indicates that Germany is in fact prepared to do more, though certainly within limits.

All told, conditions appear to be stabilizing in EU banking circles and government debt markets as opposed to worsening, suggesting greater potential for EUR stabilization at the minimum. Add on excessive EUR short positioning and we think there’s potential for a correction higher.

Increasing Prospects for QE3 May Reverse USD Strength

Developments in the Eurozone also do not happen in a vacuum. This past week, we heard from additional FOMC policymakers that there is a strong case for additional stimulus to aid the US recovery. Going by recent speeches and comments, we think there is now a clear consensus on the FOMC for another round of asset purchases targeting housing by buying additional mortgage-backed securities.

In line with our 1Q markets outlook, we don’t expect QE3 until later in the 1Q/early 2Q, but the initiative will be discussed at the Jan. 24-25 FOMC meeting. We’re not expecting the statement from that meeting to make a more concrete commitment to QE3, but the discussion of the topic could be revealed in the minutes of the meeting when they’re released on Feb. 15.

Importantly for trading conditions, we think the prospects for QE3 are increasingly driving movements in the USD, which has in turn reduced the previously high inverse correlation with risk sentiment.

Generally speaking, the new dynamic appears to be that the more likely QE3 becomes, the worse it is for the USD. Looking ahead, we think the USD’s moves will increasingly follow the direction of incoming US data, where improving US data sees the USD strengthen (as it lessens the case for QE3).

Conversely, disappointing or weaker US data will tend to see the USD weaken (as it strengthens the case for QE3). In this regard, as speculation builds surrounding potential for a QE3 announcement in the Jan. 25 FOMC decision, we think USD weakness may become apparent, providing yet another potential catalyst for a EUR rebound.

By Brian Dolan, chief currency strategist,

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