Euro faces more selling as sovereign risk woes rise

By Naomi Tajitsu

LONDON (BestGrowthStock) – The correlation between the euro and euro zone sovereign debt risk has tightened in past weeks, and revived concerns about the region’s most indebted countries may well knock the euro when the summer trading lull ends.

The specter of more government bailout funds for troubled Allied Irish Bank last week reheated worries about fiscal and financial sector weakness in some euro zone countries, which had taken a back seat when riskier currencies rallied in June and July.

But painful austerity measures implemented by heavily indebted countries including Greece are choking economic growth, and more signs of weakness in those countries will raise their sovereign risk and add to euro negative sentiment.

The European Commission said on Friday Greece should cut government spending by 4 billion euros more this year to offset revenue shortfalls and slippages.

Some analysts say such countries may face difficulties shifting new bonds when the auction schedule begins to fill up in September, adding that if the costs to insure their debt against default rises as a result, the euro will likely take a hit.

The 60-day correlation between the daily change in Markit’s Western European SovX index and spot euro/dollar is currently around -0.47, after hitting -0.59 in May.

The correlation between the euro and the index, which tracks the five-year credit default swaps of 15 euro zone countries and others, has strengthened after loosening to around -0.42 earlier this month.

Simon Smith, chief economist at FXPro, said he expected a tighter link in the coming months.

“If the correlation increases and we see credit default swaps widen, the euro could react,” he said, adding that he saw the euro falling toward $1.20-1.25 in the next three months.

The SovX index has been climbing steadily since the start of the month in tandem with a rise in CDS for Greece and Ireland. The latter jumped last week when the European Union approved plans for a bigger-than-expected bailout for Anglo Irish.

On Friday it was at 141, up from 110 at the start of August.

FOCUS ON DEBT AUCTIONS

The SovX rose close to 170 in May and June, and its rise to its highest since the euro zone debt crisis began coincided with the euro’s slide to a four-year low of $1.1876 in early June.

The euro rebounded to $1.33 earlier this month, when strong euro zone economic data contrasted with signs the U.S. recovery is losing team. It has since retreated and traded around $1.2700 on Friday.

Despite the euro’s corrective bounce through early August, Commodity Futures Trading Commission data shows speculators remain net short on the euro, as they have all year. This suggests that a significant reversal from weakness seen for much of 2010 is unlikely.

In addition, one-month euro/dollar risk reversals remain firmly in favor of puts, indicating that the path of least resistance is to sell the single currency. The premium to sell rises further along the maturity curve, suggesting the market sees more euro weakness in the future.

The latest bout of euro selling came after the U.S. Federal Reserve last week said the U.S. and global economic recovery was losing steam, striking a nerve with investors who became even more jittery with the Allied Irish news.

“The Fed’s signing up to the negative growth story shocked market … and nerves were rekindling last week, particularly related to Irish banks, and hence the euro came off,” said Neil Mellor, currency strategist at Bank of New York Mellon.

At the same time, many in the market expect solid euro zone growth — in particular a stellar second quarter reading in Germany — is unlikely to extend into the latter part of the year, and this may hurt the euro.

“As the recent outperformance of the euro zone economy over the U.S. economy fades we expect downward pressure on the euro to build,” Lee Hardman, currency analyst at BTM UFJ said in a note.

(Editing by John Stonestreet)

Euro faces more selling as sovereign risk woes rise