An increasingly difficult search for dollar funding by euro zone financial institutions will gradually push the euro lower but only a major event such as a sovereign default or a break-up of the currency bloc would trigger a precipitous fall.
The euro has so far held up well against the dollar, trading around $1.35 and still 1 percent higher on the year, despite the spreading euro zone debt crisis. But selling of euro zone assets by spooked investors is likely to see increased demand for the safe-haven dollar.
A key barometer of cross-border funding stress -- the euro/dollar cross currency basis swap -- hit its highest level since the collapse of Lehman Brothers in 2008 when dollar funding dried up and banks refused to lend to each other.
European banks scrambled for dollars and the euro slid to around $1.2330 in October 2008 from above $1.60 in July.
These three-month cross currency basis swaps, which measure the premium banks have to pay to exchange euros for dollars, have surged to 136 basis points. They have risen by 21 basis points this week alone and many believe this is just the start.
As the premium for three month funding rises, banks will have to move to shorter-term sources of dollar funding, eventually driving them into the spot currency market.
The longer it lasts, the more bearish it is for the euro, said Sebastien Galy, FX strategist at Societe Generale. So far it hasn't acted as an accelerant but that can happen if a credit event takes place or the ECB stops buying Italian bonds.
For the euro, a higher premium reflects the dollar funding pressures faced by euro zone banks and financial institutions as a sovereign debt problem mutates into a banking crisis.
Banks have huge exposure to depreciating peripheral sovereign debt and this raises concerns about counterparty risks that spill beyond the euro area.
The bankruptcy of MF Global, which had huge leveraged exposure to euro zone peripheral debt, highlights these risks.
U.S. money market mutual funds also have huge exposures to the euro area and have been a major source of funding. Analysts at JPMorgan Securities said such funds have steadily cut back their lending to the currency bloc since May.
The tightening of dollar liquidity conditions is evident in the sharp drawdown of the dollar cash held by foreign-related institutions at the Federal Reserve, which are believed to be mainly European, reducing their dollar liquidity buffer.
After peaking at around $1.1 trillion in July, dollar cash assets held at the Fed have fallen sharply to just over $700 billion in early November. They are likely to be even lower judging by the almost $200 billion drawdown over the last reported month, Bank of Tokyo Mitsubishi UFJ says.
All this does not bode well for the euro. Strategists at Morgan Stanley say these strains leaves them comfortable with their call of a higher dollar and a lower euro.
Banks typically prefer to secure funding for three months and beyond, but dwindling access to this type of funding raises the possibility that banks simply sell euro-denominated assets to raise cash in the spot market, adding to the euro's slide.
In a bid to stem the rising demand for dollars in cross currency swap markets, the European Central Bank announced in September a series of tenders at which banks can post collateral in return for an unlimited amount of U.S. currency.
This gave short-term relief to basis swaps and to the euro. But demand for the ECB's dollars has been low and funding via the cross currency market has since become even more expensive - reflecting banks' reluctance to turn to a lender of last resort.
There appears to be some significant sensitivity around those auctions, meaning that a lot of buyers don't turn up for the ECB's dollar tenders unless they really have to, said ICAP analyst Chris Clark.
I don't think anybody would be keen to disclose to the world that there is a shortfall, in that European borrowers aren't able to get dollars.
Banks borrowed just $395 million from the ECB at the latest offering on November 9, despite the higher cost of raising dollars through cross currency swaps. The premium to swap euros into dollars has widened from 81.5 bps since September.
The premium attached to funding via cross currency basis swaps could rise even further, analysts said, with more than just the stigma of turning to the central bank stopping financial institutions from resorting to cheaper ECB option.
A shortage of the assets needed to temporarily hand over to the ECB in exchange for dollars means the cross currency basis swap market -- where no collateral is needed -- will remain the preferred choice, even if premiums continue to rise.
Highlighting the collateral shortage affecting some euro zone banks, the head of UniCredit
Banks will likely be very willing to pay a premium for the unsecured, FX-derived dollar funds rather than secured ECB dollars, Clark added.
(Editing and graphic by Nigel Stephenson)