Last week started with the euro (EUR) plunging to 2½-month lows against the USD amid concern that the Irish bailout was not big enough and contagion fears to other euro zone members. The single currency reversed course to rally in the latter part of the week as the European Central Bank (ECB) announced it would continue to provide liquidity to the system into Q1 2011. While U.S. QE2 and liquidity injections were deemed a USD negative a few months ago, the opposite was the case for the EUR.
The euro can certainly bounce from the heavily oversold levels, but it is questionable any such bounce could develop into a sustainable rally. The situation in Europe is still problematic and would continue to weigh on the EUR. The programs already put in place by the policy makers seem sufficient to take Greece, Ireland and Portugal off the capital markets and thereby prevent contagion to the rest of the euro area. However, the market is concerned that Spain, whose economy is twice the size of Greece, Ireland, and Portugal combined, may need a bailout like that of Ireland. In addition, there is also the risk that debt contagion will spread outside the PIIGS into the heart of the euro zone, with Belgium and France the next suspects. As such, the risks to the EUR are firmly to the downside in the medium term.
However, a couple of developments may have given relief to the EUR in the near term. The EUR is likely to decline, but only modestly in the near term.
First, last week, Portugal and Spain carried out successful auctions and the ECB announced an extension of the Securities Market Program (SMP) which helped to tighten peripheral countries' yield spreads. The ECB announced weekly bond purchases of EUR 1.965 billion last Friday, compared to EUR 1.35 billion the previous Friday. This marks the highest weekly volume of purchases since July and takes the total size of the SMP since its introduction on May 10 to EUR 69.1 billion.
By stepping up significantly its purchases on the countries currently part of the program (Greece, Portugal and Ireland), it is suggesting to market participants that its resolve to support the system remains. The ECB seems to be prepared to increase the number of countries targeted to prevent contagion spreading to larger economies. The ECB has also delayed the exit from its emergency liquidity measures. All of this lent support to EUR despite the ongoing worries about euro zone peripheral government debt.
Second, Bernanke confirmed the idea of a possible QE3. During his CBS TV interview on Sunday's "60 Minutes," Bernanke confirmed the possibility that bond purchases could be more than the $600 billion already earmarked for QE2 if necessary. He clarified that QE2 was not in "automatic motion" and is subject to regular review, depending on the program's efficacy, inflation and the economy. Bernanke also painted a bearish picture on the jobless situation, suggesting it could be over five years before unemployment falls back to more normal levels.
The weaker-than-expected jobs report of Friday has helped Bernanke in his cause to defend the QE program. On the other hand, it is also a reminder that while the EUR has its fair share of problems with the peripheral euro zone sovereign debt, slow growth and the FOMC's QE programs are significant negatives for the USD. The prospect of a QE3 could continue to move interest rate differentials against USD going forward. Indeed, while we have seen some correction in USD crosses so far, the widening in yield spreads of G10 currencies against the dollar has confirmed this. Similar to the last round of QE2, FX rates could follow suit in the very near term with USD weakening again across the board. Moreover, the Fed's policy stance to expand quantitative easing will likely to underpin the recovery in market risk sentiment going forward. Based on recent trading patterns, USD is unattractive in a world of normal risk appetite while risk-loving currencies will outperform against the greenback.
Current market sentiment is not in favor of EUR, evidenced by the latest CFTC data which show large speculations flipped to net short EUR positions for the first time since mid-September. And one can argue that this is just the beginning of a prolonged period of EUR weakening. On the other hand, USD has been bought not because of its positive fundamentals. Part of the USD recovery was due to the unwinding in the past couple of weeks; extreme short positions accumulated in the USD. The conflict between the EUR and the USD will cause EUR/USD to continue to be jittery, depending which currency's economic woes are in the forefront. Despite the medium term outlook of a lower EUR, the single currency will likely decline modestly in the near term.
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