The euro is due a respite after a very hard winter

Kathleen Brooks
THE EURO’S winter of discontent started back in January when a huge hole in Greece’s public finances was revealed. Since then allegations of dodgy accounting rules, swap trades with major Wall Street banks and the threat of contagion to other southern European economies has driven the euro to multi-year lows.

But has the euro been punished enough after falling 20 cents against the US dollar since the start of the year, and could the single currency emerge from the shadows as we move through the second quarter? There is a strong argument to suggest that the euro’s decline won’t be as dramatic in the coming months.

Firstly, short positions in the euro are at a record high, particularly against the US dollar. Even Michael Hewson, technical analyst at CMC Markets and a euro-sceptic, says this bodes well for the single currency: “It gets to the stage when so many people have the same position, that euro-US dollar becomes susceptible to some upward pressure.”

Secondly, the narrowing interest rate differential between Europe and the US has helped fuel dollar strength against the single currency. Currently traders in the Chicago federal-funds futures market are betting that the Federal Reserve will raise rates to 0.5 per cent (currently rates are close to zero) by its September meeting. But this could be too optimistic.

There are two reasons why. Firstly, inflation in the US has remained subdued during the economic recovery. In February prices excluding food and energy rose by a meagre 0.1 per cent over the month and a mere 1.3 per cent during the year. Inflation expectations also remain low. Secondly, although the US recovery has gained some traction, it remains weak. As Capital Economics, the consultancy, points out, although the US economy created 162,000 jobs in March, it took nine months since emerging from recession for the economy to create a meaningful number of jobs. In a note sent out to its clients yesterday, Capital Economics wrote: “Treasury yields should drop back in the second half of this year as the recovery runs out of steam and as inflation falls further.”

But, investors should be mindful that a recovery in the euro is unlikely to have a smooth upward trajectory. Just yesterday yields on Greek government bonds surged by 60 basis points. Even though the European Union and the IMF have agreed to help Greece in the event that it can’t finance itself in the capital markets, investors are still demanding a high risk premium to hold onto the government’s debt. The next auction of Greek debt is in May, when George Papandreou’s government has to refinance €20bn.

Because of the continuing problems with the Greek economy, investors who think that the euro has fallen too far should look at the technical picture before they trade the single currency. The euro is currently trading below $1.34, which is a significant support level. But watch out for revised GDP data for the Eurozone, which is due out later today. If it is stronger than the 0.1 per cent economists expect then the euro could spring back above this important level.

CMC Markets’ Hewson says that the next key resistance level is $1.3570, and if the euro can break through here in the coming weeks then the next high could be $1.38.

The euro has been under extreme selling pressure this year and is in need of a break. For the contrarians out there, buying the euro on the dips could reap rewards in the coming months.