Euro Declines in Store as Spain’s Bond Yields Warn of Further Crises

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Fundamental Forecast for the Euro: Bearish

The Euro tumbled to fresh multi-year lows as markets reacted to a flare-up in European financial market tensions, and an aggressive European Central Bank interest rate cut may continue to weigh on the single currency moving forward.

What a difference a week makes. It was exactly seven days ago when a highly-anticipated European Summit forced a new wave of optimism across European markets and a substantial Euro rally. Yet price action into this week’s close served as clear sign that troubles are far from over. Spanish 10-year bond yields jumped by an astounding 80 basis points off of post-summit lows to close at 6.95 percent. It was above 7 percent yields that Greece, Ireland, and Portugal were forced to seek international bailouts as borrowing costs proved unsustainable. The risks to the Euro Zone’s fourth-largest economy are clear.

The European Central Bank did what it could to ease market tensions, cutting its benchmark interest rate by 25 basis points to 0.75 percent and its deposit rate to an unprecedented 0 percent. Put simply, the ECB will no longer pay interest to financial institutions holding reserves at the central bank. The move serves as a clear incentive for banks to lend money to the private sector and perhaps even to the public sector, as they will earn nothing at the central bank. Yet European periphery nations remain in clear recession and contagion to Euro Zone core economies warns that banks will likely remain unwilling to lend through the foreseeable future. Monetary policy will only go so far when banks are deleveraging and holding reserves as existing loans turn sour.

Where does this leave us? With an almost-humorous sense of déjà vu, markets now look to yet another European summit through the early week which is expected to clarify the conditions surrounding bailouts for Spain and Cyprus. The weight of expectations remains quite low as most have grown used to the lack of clear action from these summits.

Forex traders are voicing their opinions through positioning as recent CFTC Commitment of Traders data shows that large speculators increased their net-short EURUSD position in the week ending July 3. Said positioning is near its most bearish on record. It’s interesting to note that FX Options traders are near the opposite end of the spectrum; the difference in prices paid for bullish and bearish EURUSD options is at its most optimistic since the Euro traded near $1.30. Options traders are still paying a significant premium for bets on/protection against EURUSD declines (out of the money Euro puts), but that premium has been shrinking since the EURUSD set a short-lived bottom of $1.2290 in May.

We’re strong believers that past performance is not necessarily indicative of future results, but looking at the past gives us a better sense of what is more likely to happen in the future. Seasonal tendencies show that it has been exceedingly rare for currency pairs to set yearly highs and lows through the month of July. Given that the Euro just broke to fresh year-to-date and multi-year lows through Friday, this leaves square focus on current monthly lows at $1.2260. Can the currency pair defy seasonality and hold above $1.2260? Anything is possible. Yet probabilities leave us focused on a further break lower, and indeed our own retail sentiment-based systems point to fresh EURUSD declines.

Overall price trends remain clear, and the Euro’s most recent tumbles point to further weakness into the days ahead. Event risk will be relatively limited with the exception of the European summit on Monday and Tuesday. Yet that hardly rules out sharp market moves. Indeed, marked deterioration in Spanish bond prices (surge in yields) emphasizes that financial market stresses are real. Expect the Euro to decline if Spain’s bonds cross once again above the 7 percent mark as European fiscal crises remain center stage. - DR

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