Greece pushes the euro into uncharted seas

Kathleen Brooks
EUROPEAN woes went from bad to worse yesterday after Standard & Poor’s, the rating agency, downgraded Greek and Portuguese debt. Greek debt at BB+ is now effectively junk status. Investors dumped the euro, causing it to fall nearly two cents against the US dollar.

But what now for the single currency? It managed to maintain its support level of $1.32 against the US dollar in trading yesterday: “Now that the downgrades have happened, I think it is only a matter of time before the euro buckles. When this happens I expect the euro to go straight down to $1.3050. From there, if the problems continue, it could go as low as $1.27,” says Michael Hewson from CMC Markets.

The euro looks especially vulnerable against the US dollar. The Federal Open Market Committee (FOMC) meets today and is expected to reiterate that the growth outlook in the US remains firm. This is likely to fuel further selling of the euro as investors price in the likelihood that the US will start raising rates before Europe.

Surprisingly, from a technical point of view, the euro has held up fairly well in the face of ongoing problems in southern Europe and has not been pushed below $1.32, an important support level. But a further bout of weakness could be around the corner for two reasons. Firstly, as CMC Markets’ Hewson points out, Greece may have to resort to a default on its obligations: “Greece’s two-year bond yields hit more than 17 per cent after the downgrade, and it seems only a matter of time now before Greece defaults, and has to re-structure its debt.”

Part of the euro’s resilience has been due to expectations of a white knight rescue by Germany, but this looks remote. Popular opposition to a bail-out in Germany has effectively tied Chancellor Angela Merkel’s hands until after regional elections on 9 May.

Secondly, Europe’s other troubled economies also look under increasing pressure. Portugal – which was also downgraded along with Greece – Spain and Ireland saw the cost of insurance for their debt also jump. At this juncture Europe’s debt problems could spiral out of control very quickly: “Spain and Portugal also have a massive debt pile, but they have to contribute to the European Union’s bail-out of Greece,” says Hewson. “They don’t have the money to contribute to a bail-out fund, so Greece’s problems are only going to compound their own.”

But what could happen to the euro in amongst the political mess of sorting out Greece’s debt? Phil McHugh, corporate dealer at Currencies Direct, says that Europe’s largest economies – France and Germany – don’t want to merely bail out Greece, which would placate the markets, in case this sparks moral hazard across the region.

Hewson says that the only way to sort this problem out once and for all is for there to be a two-tier system within the euro: “We are in uncharted territory at the moment, but it’s clear that for Germany the euro is not over-valued whereas it is for economies in southern Europe. To resolve this problem either Greece steps out of the Eurozone or Germany does.”

But a note from analysts at BNP Paribas was more confident that the euro will remain as it is: “It remains primarily a political project and (the euro’s) structure will simply adapt to the current environment as it always has, much as the US dollar did when the US let a handful of states go bankrupt in the 1830s.”

As Europe thrashes out a deal to help Greece the markets are unlikely to be placated. Further uncertainty means only one thing: more euro weakness.