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The euro is a strange beast. Italy is on the brink (although it has taken a step back from the edge today) and the euro hasn't collapsed.
Although Italian bond yields may have retreated by a few basis points, essentially we still don't know what the future of the Eurozone will be, who will lead Italy as it tries to get its fiscal house in order and whether or not the euro will still be in its current form in 12 months' time.
At the time of the Greek crisis Part 1 back at the end of 2009, the single currency embarked on a 20% downtrend until it started to recover in June 2010. So why, now that the crisis has escalated and Italy is in the firing line, hasn't the euro been under similar attack?
There are a couple of reasons for this. Firstly, the positive correlation between the S&P and the euro has increased dramatically since the peak of the Greek debt crisis. It now stands at 0.88, compared with 0.55 back then. Thus, the euro is more closely aligned with risk and thus the global growth environment than with the euro. This means that developments on the global stage - such as lose monetary policy, strong economic data in the US, good corporate profits - can act as a counter balance to strains in the sovereign debt market.
This can still be difficult to understand since logic would suggest that the euro should get hit as the contagious effects of the sovereign debt crisis start to grow. However, we postulate that QE by the Federal Reserve has made the euro more attractive than it normally would be and distorted the way that EURUSD should react during the sovereign debt crisis.
When the Fed embarked on its second round of QE back in November last year it did two things: 1, cause a massive shift out of the dollar and into risky assets (including the euro, stocks and commodities). 2, stoke fears about a currency war that damaged the Fed's reputation. However, once the Fed puts its hand on the printing press there is no point standing in the way of that steam roller. The Fed doesn't want a strong dollar, and it has the tools to ensure this does not happen.
The prospect of QE3 may not be forthcoming, but it is still an option for the Fed to use if the Eurozone crisis does start to threaten global growth. No one wants to get the wrong side of the Fed right now, and the more stress in sovereign credit markets the more likely the Fed is to do more QE. So, when the Eurozone debt crisis notches up a gear, this makes QE more likely, which is negative for the dollar in the long-term.
This may be a crude explanation but it does go some way to explain the performance of the euro. As you can see in the chart below: as Italian bond yields have surged to bailout territory - especially in the past 2 weeks - the euro has traded in a tight range. Essentially the euro is being tugged in two opposite directions: downwards by Italy's financial stress, yet the prospect of QE3 has a buoyancy effect on the single currency that is stopping it from sinking.
EURUSD (orange line) and Italian 10-year bond yield (white line)
So what else could impact the single currency? Right now there is almost universal concern that monetary policy needs to remain low to ensure that the sovereign debt crisis doesn't push the global economy into recession, so relative interest rates are unlikely to be a major driver of FX going forward.
So what could happen to the direction of the euro in the medium-term? The EU Commission today predicted that the Eurozone would grow by a measly 0.5% next year - only just above recessionary levels. This is in contrast to the US , where the Fed has also revised down its growth forecast but only to 2.5% - 2.9%, from its earlier estimate of 3.3% to 3.7%. So if the markets start favouring a growth trade then this should be extremely dollar positive.
But what if the euro breaks up? This wouldn't necessarily spell a collapse of the euro either, since if Germany was to lead a preened euro with only fiscally strong members then, potentially, a new super euro would be priced off the original single currency.
But this doesn't mean that the euro is out of the woods. It is still vulnerable to a sell off fuelled by a ratings downgrade, bank run or further stress in Italian, Spanish and even French bond markets. From a technical perspective, in the short-term the break below 1.3600 in EURUSD yesterday - the bottom of its recent range - is bearish. Below here there is a support zone at 1.3400 but below here there isn't much support ahead of 1.3150. But for the euro bears out there looking for parity, don't expect the single currency to go down in a straight line.
EURUSD: daily chart, the MACD and RSI is also pointing lower on a longer-term basis
Kathleen Brooks| Research Director UK EMEA | FOREX.com
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