By FXEmpire.com
In the last few days, the EUR/USD dropped below the January lows at 1.2624. This was a high profile support level and the break below suggests that EUR/USD trading has entered a new phase.
The euro is paying an ever bigger price for the inability of Europe to solve its economic- and financial crisis. Several months ago, we warned that EU was running out of time, market thought that a simple resolution in Greece had settled the matter, but it was inevitable that the bigger picture was not looked at or resolved. When I wrote 3 months ago, that I was going to try to stop writing about Greece for at least 90 days, I was wrong; it took less than 60 days for the dyke to break.
With the start of the Greek crisis, the flaws of the euro construction have become an important driver of the debt crisis. Investors questioned the adequacy of the EMU institutional framework to handle the impact of the global debt crisis on the EMU area. EUR/USD set a crisis low at 1.1877 in June 2010, after the first Greek rescue package. Doubts on the EMU construction were not constantly present throughout the whole period and other issues played a role, too.
Late 2010, EUR/USD profited from overall dollar weakness as the Fed announced more monetary easing in the US (QE2). In the first half of 2011, the euro profited when the ECB started its policy normalization and raised rates twice. In a broader perspective, the euro held up well during the (European) debt crisis. This was partially due to underlying weakness of other major currencies (USD) but also because investors were confident that the ECB wouldn’t use inflation as a tool to solve the EMU debt crisis (in the end, deflation is supportive for the currency). At the same time, markets held to the basic view that, in the end, the EMU construction would survive the debt crisis. As long as the euro remained over the 1.30 psychological point it seemed that markets were happy and ministers could just continue to about their day to day business. Economists warned that we needed an overall encompassing plan for the EU, but Merkel and Sarkozy continued to pursue their austerity measures and their one by one conflict resolution scenario.
Since mid 2011, the EMU debt crisis entered a new phase. The July EMU Summit failed to convince markets that the EMU had a credible strategy to keep the debt of the peripheral EMU countries on a sustainable path. The ECB had to backtrack on its normalization call. The policy rate hikes were reversed and the bank took several unconventional measures to mitigate financial stress on the intra-EMU sovereign bond markets and to guarantee liquidity in the banking sector. So, the ECB lost its aureole as prime anti-inflation fighter and came close to printing money as did other central bankers. The euro lost its comparative ‘advantage of orthodoxy’ and EUR/USD reached a correction low at 1.2624 in January. The ECB’s 3-year LTRO’s removed temporary market fears that peripheral European sovereigns would lose market access. Global sentiment on risk improved and the euro entered temporary calmer waters.
At the end of April, the period of relative calm ended. The LTRO brought some relief, but not enough to avoid countries like Greece, Spain or Italy to be captured in a negative spiral as increased austerity efforts reduce growth further. Questions about the debt sustainability in these countries only increased as low/negative growth raises the weighted of debt on the economy. In addition, the election results in Greece and France indicated that the political backing for austerity and fiscal consolidation is faltering. A Greek exit has become a real possibility.
Aside from the fundamental issues, the cyclical developments are also conspiring against the euro. The EMU avoided a recession in Q1 as German growth was unexpectedly strong. However, recent survey evidence indicates that the economic situation in Europe is deteriorating at an accelerating pace, not only in the periphery, but even in core countries like Germany. In this context, more monetary easing from the ECB, including a rate cut at the July or even at the June meeting is highly likely. The likes of the BoE and the Fed might also take additional steps to support the economy if the outlook on global economic growth would deteriorate further.
However, in any scenario, the ECB will be seen as having the biggest job to do and as the last one to start policy normalization, whenever that will be.
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Originally posted here
