SINCE the start of the year the euro has surprised many market participants by staging a vicious short covering rally that has added more than 500 points to the pair over the past two weeks. There were three key reasons for the euro’s recent strength. First and foremost, the Eurozone credit markets have become markedly less volatile as the European Central Bank (ECB) provided massive liquidity through its Long Term Refinancing Operation facility, while the European Union, International Monetary Fund and ECB continued to work on the bailout of Greece. Secondly, the economic data in the US and core Europe has been remarkably resilient, sparking hopes that global economy will avoid a recession in the first half of this year, which should prove supportive for risk assets such as the euro. Last but not least, the euro remains grossly oversold with the latest Commitments of Traders report showing that the euro shorts continue to increase to record highs, thus creating a massive positioning imbalance that makes the pair vulnerable to quick short covering rallies.

Lately, however, these three pillars of euro support are beginning to wobble. On the credit front the situation in Greece remains unresolved. Although the reports over the weekend suggested that the two parties were close – agreeing on a 60 per cent haircut and a coupon just below the 4 per cent rate – no formal announcement has yet been made – frustrating some market players who had been expecting a deal to be concluded. Meanwhile, Greek Prime Minister Lucas Papademos said that unless the country’s international backers agreed to a new bail-out, Greece would be unable to pay off its loans and be forced out of the Eurozone. Without that bailout, Greece will be unable to repay €15bn of loans due in March.

Over the weekend Germany suggested that a European commissioner should take effective control of Greek fiscal policy to ensure that the country implements key austerity measures. However, Evangelos Venizelos, the Greek finance minister, rejected that plan, saying it would undermine Greece’s “national identity and dignity”. Greece remains the key to further euro gains, not only because a failure to reach a compromise could trigger a hard default, but also because a successful deal could act as a template for possible rescues of Portugal and Ireland as the year progresses.

The macro economic picture has also become considerably less rosy over the past few days. Last Friday, the market received a nasty surprise when the US GDP data printed at 2.8 per cent versus 3.0 per cent eyed. Worse yet, US personal consumption was markedly weaker at 2.0 per cent versus 2.4 per cent forecast, suggesting that consumers remain cautious. This week’s calendar is chock full of important economic releases including German Retail Sales and Labor data due tonight, US ISM Manufacturing on Wednesday and Non-Farm payrolls on Friday. If the data prove disappointing, the global rally in risk could come to a grinding halt, as fears of a slowdown once again grip the market.

Finally, even the positioning data may not prove to be as euro bullish as it appears. The latest snapshot that we have was taken last Tuesday, just before the large euro rally sparked by the dovish Federal Open Market Committee (FOMC) press conference. That means the euro short position was very likely reduced substantially, relieving some oversold conditions in the market.

In short, euro longs may now find themselves in a perilous situation if the sovereign debt problems remain unresolved, the economic data begins to disappoint and market positioning is no longer skewed to the short side. Technically the pair has hit resistance at the $1.3200 level, and will now need a confluence of positive factors to propel it higher. Otherwise it can quickly tumble back to the $1.20s as all the old worries return.