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EUR: 4 Reasons Why the Rally Fizzled

Last updated 11/14/2011 9:55 AM ET (GMT -5) 0 Comments - Add your comment

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Kathy Lien

Director of Currency Research, GFT

When the markets opened for trading Sunday afternoon, news of Berlusconi's resignation sent the euro above 1.38. Unfortunately the rally did not last with the EUR/USD sold aggressively throughout the European trading session.  Now that U.S. traders have joined in on the action, the selling has not dissipated one bit. The leadership change in Italy is the best news that we have heard from the boot-shaped nation in weeks because it brings in a technocratic government that will hopefully implement real changes to the debt stricken nation. Yet the good news failed to have a lasting impact on the euro because as of this second, there is still more risk that relief for the Eurozone economy.  The primary job of the technocratic governments in Italy and Greece are to implement austerity packages that will reduce debt at the expense of growth.  The prospect of tougher times in the coming months means that we could be entering a phase of even slower growth in the Eurozone economy that is bordering on recession. 

There are 4 reasons why the euro has given up its early gains and each one of them relate back to concerns about Eurozone or Italian growth.

1) Weak Italian Bond Auction

This morning's Italian bond auction was the first test of investor confidence since the appointment of Mario Monti as Italy's new Prime Minister.  Although Italy managed to sell all their bonds, the 1.5 bid to cover ratio was extremely weak.  The bonds were also sold at a yield of 6.29 percent, nearly a full percentage point higher than the rate paid at a similar auction last month and also the highest in 14 years.  Ten year Italian bond yields are crawling back towards 7 percent and as we mentioned last week, the correlation between the EUR/USD and 10 year Italian bond yields have been exceptionally high. With Spanish, Greek and Portuguese bills being auctioned throughout the week, the market's appetite for European bonds will remain in focus.

2) European Road Show in Asia Fails to Attract Much Demand

Representatives of the European Financial Stability Facility (EFSF) have been touring across Asia in an attempt to attract China and Japan's sovereign wealth funds to buy its bonds.  Unfortunately it appears that Europe has done a poor job of alleviating the concerns of Asian investors who refused to snatch up all of the EFSF bonds sold last week.  According to The Sunday Telegraph, the EFSF was only able to find about EUR2.7 billion of outside demand for their debt and had to spend more than EUR100 billion to buy its own bonds.  Investor confidence has been a major issue in the Eurozone and even with the backing of Germany, the AAA rated EFSF has faced major challenges in attracting foreign demand which has caused Moody's to raise concerns about the EFSF's ability to fund itself in the market and to stabilize debt prices.

3) Weidmann Says Don't Expect Support from the ECB

Comments from ECB member Weidmann also discouraged investors from buying euros. In a speech earlier this morning, Weidmann said using monetary policy for fiscal needs must stop and he rejected the idea of the ECB becoming the lender of last resort for governments.  This view is shared by many other members of the monetary policy committee including former ECB President Trichet but if the debt crisis continues to escalate, the central bank may have no choice but to overstep their mandate. 

4) A Future of Weaker Growth

The final reason why the euro gave up its gains so easily is probably the most important. We are moving into a period of aggressive austerity in many parts of the world including the Eurozone, U.S., U.K. and Japan. The deadline for implementing budget cuts in the U.S. is rapidly approaching and unfortunately it comes at a time when global growth is extremely fragile.  In Europe, the sovereign debt crisis and budget cuts are expected to slash growth next year to 0.5 percent according to the European Commission.  This means that for most of Europe, next year will be a period of stagnation bordering on recession. To prop up growth, central banks could ease monetary policy further and for the ECB this means more rate cuts. The central bank's decision to lower interest rates earlier this month could be followed by another rate reduction in December as incoming economic reports show further weakness.

Although Europe will remain in focus this week, the abundance of economic data from the U.S. and U.K. could shift attention over to the U.S. dollar and British pound. Unfortunately more weakness than strength is expected for most of this week's economic reports which means the selling of currencies and equities could continue.

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About The Author

Kathy Lien began her FX trading career 10 years ago at J.P. Morgan Chase. After graduating New York University’s Leonard Stern School of Business at the age of 18, Kathy joined the bank's interbank FX trading desk and eventually moved to the cross markets proprietary trading desk. In the interbank market, her ability to create solid fundamental and technical analysis from the myriad of information on the market helped her trade forex spot and options. Her experience eventually led her to be chief strategist at Daily FX where she worked until she joined GFT in 2008.

With her knowledge of forex, as well as her experience trading other products, such as interest rate derivates, bonds, equities, and futures, Lien has built a reputation as an international currency analyst. She is frequently quoted on CNBC, Bloomberg, Fox Business and Reuters. Lien has also written for publications like Active Trader, Futures, and SFO magazine. She is the author of the newly updated Day Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, and the co-author of Millionaire Traders: How Everyday People Are Beating Wall Street at Its Own Game with Boris Schlossberg.

To buy Kathy’s newly updated Day Trading and Swing Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, click here.