The euro still has further to sink against the greenback

SOVEREIGN debt problems in Europe have spiralled in recent weeks. So much so indeed, that BNP Paribas’ currency strategists Hans Redeker and Ian Stannard reckoned last week that the euro would fall to parity with the US dollar by the first quarter of 2011. Even the super-sized €750bn bailout package to extinguish the financial flames that are engulfing the Club Med economies, which was announced over the weekend, hasn’t been enough to change their minds.

And while BNP Paribas is the most bearish on the euro by some way (see chart), they are not alone. The package has not been enough to placate the markets or prop up the euro for long – its strong start to trading on Monday quickly fizzled out. And many analysts expect it to weaken further against the US dollar from its current level just around $1.27.

But why are the markets continuing to punish the euro even after European authorities have promised their support? There are signs that the bailout plan hasn’t gone far enough. “Although Greece’s short-term liquidity issues may have been addressed, many are rightly questioning their longer term structural solvency problems, and those of the world’s other great debtors,” says Tom Becket, chief investment officer at PSigma Investment Management.

Neil Mellor at Bank of New York Mellon says that investors will be concerned about whether the package will stop the rot: “Nobody knows where this cash is going to come from and whether it is going to be approved if and when it is needed. I don’t think the market is going to be any more trusting of a policy (the Financial Stability Pact) that has already stalled. We are going to have the same problems going forward.”

But while some are questioning the firepower of the bailout, other analysts are pointing to the structural problems inherent in the Eurozone. The bailout is only part of the solution; the main problems are structural, says Mark O’Sullivan, head of trading at Currencies Direct.

He explains: “The issue is low productivity and rising wage costs in the most troubled economies. The medicine the Eurozone needs to take is going to be painful and we’ve seen the violence that can occur when governments start to make these changes. So at this moment in time the bailout is a bit like shuffling chairs on the deck of the Titanic.”

O’Sullivan adds: “The real issue for the euro, is that in the past ten years of its existence it has never been tested: “The euro has been able to appreciate because of the weakness of other currencies, most notably the dollar. Now that the dollar is strengthening and the euro has had to trade on its own economic merits, it’s falling short.”

The dollar has been strengthening as a result of strong productivity growth in America, increasing the relative attractiveness of investments in the US and prompting dollar inflows. And with the Federal Reserve expected to tighten rates sooner than the European Central Bank (ECB) – the ECB cannot tighten policy now for fear of exacerbating the situation – the interest rate differential between the two currencies will widen, favouring dollar inflows.

But while parity is a distinct possibility – BNY Mellon’s Neil Mellor says that he certainly wouldn’t dismiss such a negative position – it is a massive drop (some 20 per cent) from where we are now. So what key levels in euro-US dollar should FX traders be looking out for in the meantime?

CMC Markets’ Michael Hewson reckons we could see $1.2135 in the next month or so, which is the 50 per cent retracement from the all-time lows in October 2000 to the 2008 highs. The next big Fibonacci level is the 61.8 per cent retracement of $1.1210. Also, pay attention to the 2008 low of $1.2330 and the 2005 low of $1.16.

A lot has to go right for the euro to recover, so there’s plenty more scope for a short euro trade, even at these depressed levels.