Fear and loathing on the edges of Europe

SOMETIMES it seems as though the foreign exchange markets can only deal with one news story at a time. Whereas a month ago, the dollar was being attacked for quantitative easing, now the euro is the point of focus. Given the depth of the fiscal problems in Ireland and Portugal and even potentially Spain or Italy, that is hardly surprising. A brief relief rally on Monday morning failed to last into the day, and the euro kept falling yesterday, losing 1.7 per cent against the dollar. An awful lot of commentators are very pessimistic about the future of the euro, but with events so uncertain, should traders be?

If the markets are particularly fickle right now, it is because there is an abundance of bad news to choose from. Until recently, monetary tightening by the European Central Bank (ECB) was strengthening the euro, and the single currency hit a high on 4 November of $1.42. With renewed fears about the solvency of the European periphery, however, that sentiment has now reversed, and the ECB’s plans to wind back liquidity support to European banks is now seen as being broadly negative.

As Richard Wiltshire, an analyst at ETX Markets, put it, “the bullies are now picking on the euro”, having interpreted easing in the US to be the lesser evil relative to the crisis in Europe. Wiltshire says that though currency traders have exhibited a degree of “lemming-like behaviour” in selling the euro, they have not overreacted. He argues that though there may be a few relief rallies, the euro ought to keep falling. With traders likely to “sell the rumour, buy the fact”, however, those falls are likely to be unpredictable.

Michael Hewson, of CMC Markets, is even more bearish. Hewson argues that the Irish crisis is far from over and may well break out of Ireland. He points to the rapidly widening bond spreads in Portugal and Spain as evidence that contagion will spread. According to Hewson, bailouts will only be able to go so far “before the ECB and the euro lose all credibility”. As that event appears to get closer, the euro should only get weaker.

Traders would seem to be wise to go short on the euro then, but they also need to avoid becoming victims of volatility. Instead of trading the euro directly, it might make sense to buy safe haven currencies like the Swiss franc, or currencies with limited exposure to a European crisis, such as the Australian dollar.

It also makes sense to look at correlations. Over the hour range, for example, the euro-dollar pairing has been strongly inversely correlated to the US dollar-loonie pairing. If those sorts of correlations last, then currency traders might be able to profit from the falling euro without being so vulnerable to sudden shifts in sentiment.

And sudden shifts in sentiments are likely to be the order for the day. Traders need to be careful not to get caught out.

ESCAPE ROUTES | AVOIDING THE EURO INFECTION

Safe haven currencies:
The Swiss franc: The traditional place to hide from European instability, but be careful - the Swiss franc tends to follow the euro in movements.

The Australian dollar: The Australian economy is rather shielded from Eurozone woe. Against the yen, it shows particularly low correlation to euro-dollar movement - watch out though: correlation does not equal causation, and correlations can break down.