Weak demand at a German debt auction suggests investors are starting to shun even the euro zone's strongest economy, which could trigger more losses in the shared currency as many shift from euro-denominated assets to safe havens outside the region.
As Italian, Spanish and even French yield spreads have blown out to record levels in recent weeks, the trend has been for portfolio flows to switch into German Bunds, resulting in no foreign exchange outflows from the euro zone.
Those flows, combined with talk of repatriation of capital by euro zone banks desperate to shore up their balance sheets as money markets seize up, have been cited as reasons behind the euro's recent resilience around $1.34.
But that appears to be changing and on Thursday the euro slid to a 7-week low at $1.3316 on trading platform EBS.
Germany sold barely half the bonds it put up for auction on Wednesday, when a buyers' strike against the low yields on offer was fueled by fears that Berlin could not remain immune from the crisis engulfing its heavily indebted euro partners.
In a sign that investors are cutting exposure to the euro zone as a whole, 10-year Bund yields converged with UK gilts for the first time in 2-1/2 years.
Normally, positive yield differentials would be considered a reason to buy the euro. But analysts said investors are now more likely to sell the shared currency because of fears that Germany
may be forced to underwrite the fiscal excesses of weaker euro zone economies. Those worries could push the euro to $1.25 or lower by early next year, some analysts say.
Some people are now saying if you cannot sell the Bund (at auction) you cannot sell anything. Traders will see German yields higher and the euro falling and say that is not a good sign. The euro zone crisis is just getting going, said Geoff Kendrick, FX strategist at Nomura.
Analysts described the recent widening of differentials between benchmark Bund yields and returns on the bonds of weaker economies as asymmetric. Earlier in the crisis, when peripheral bond yields rose German yields tended to fall.
When German Bund yields no longer drop while the other side is widening, we have liquidation of these peripheral bonds as well as simultaneously a flight out of the euro. This means the euro is much more vulnerable to widening of the spreads, said Hans Redeker, global head of FX strategy at Morgan Stanley.
At 2.15 percent, 10-year German yields are still roughly a third below levels seen earlier this year, and investors are unlikely to dump Bunds as they dumped Italian and Spanish debt.
But Stephen Gallo, head of market analysis at Schneider Foreign Exchange, said if weak demand for German debt escalates into an outright Bund sell-off, a huge proportion of flows that have remained within the euro zone would desert the bloc.
We may get to a point where Germany starts to get pressured, capital is going to be drying up and then the euro could drop quite low, to $1.25 or less in a matter of days, Gallo said.
In a scenario in which Germany comes under pressure, analysts said the portfolio flows could dry up fast.
The latest European Central Bank data showed 20.7 billion euros of net portfolio investment flowed into the euro zone in September, at a slower pace than August when 31.9 billion euros came in.
The data supports the view that appetite for euro zone debt is waning with repatriation of capital by European banks acting as a buffer for the time being. Analysts expect foreign investors to speed up liquidation of euro zone bond holdings while repatriation inflows are likely to wane in coming months.
Deutsche Bank estimates the stock of foreign portfolio investments in the euro area exceeds the stock of euro area investment abroad by close to 3 trillion euros - a mismatch that is likely to send the euro lower in coming months.
Data from Japanese bank Nomura shows domestic investors in France, the euro zone's second largest economy, has already repatriated investment from abroad for four consecutive months, to a total of 123 billion euros.
Although the data does not differentiate between repatriation from other euro zone countries and the rest of the world, it supports evidence that French banks, which have particularly high exposure to Greek debt, are trying to improve capital ratios to reduce vulnerability to a Greek default.
Nomura data also showed Japanese investors led the selling of euro zone assets mainly from Italy and Belgium in August and September, and that trend is expected to continue.
Deutsche Bank strategist Alan Ruskin said as the crisis threatened core euro zone countries, foreigners had a significantly smaller pool of assets to buy from. He forecast the single currency could hit $1.25 in the first quarter of 2012.
It does feel like Europe has jumped the gun and there's a mismatch in terms of repatriation. Foreigners hold a lot more European assets than Europeans hold foreign assets. There's more to liquidate in a full-blooded, 'everyone goes home' situation.
(Editing by Ruth Pitchford)