MARKET TOO COMPLACENT ON THE EURO

YESTERDAY, while London was sleeping and Tokyo traders were just starting their day, Standard and Poor’s downgraded Italy, sending euro-dollar into free fall, as the unit plunged more than 100 points in a matter of minutes. Yet when London traders arrived at their desks, the pair proceeded to stage a comeback recovering all of its losses. Why does the euro remain so resilient in the face of so much bad news? I believe the currency markets are just too complacent, convinced that the member nations will somehow muddle on through the growing credit crisis in the region.

Yet Italy is a much bigger problem than Greece. The country’s bond market is the third largest in the world. The downgrade could increase Italy’s borrowing costs, just as the country embarks on a large refinancing program that entails nearly €30bn of gross issuance in October and November. These upcoming bond auctions could become the true test of the country’s credit strength, and if investors balk at rolling over its debt, the downward pressure on the euro could quickly accelerate.

At the very best, Italy will now have to pay considerably more money to refinance its debt, a dynamic that will dampen growth going forward, as government revenues are used for interest payments, rather than direct spending. That’s a prescription for a recession that could spread to the core of the Eurozone by the start of next year.

Today, all eyes in the currency markets will be focused on the Fed to see if Bernanke and company introduce the new policy of Twist – a way to shift Fed assets from short-term maturities to the long end of the yield curve. However, I believe these financial gymnastics will have little long-term impact on currency trades. Rates in the US are low enough and yet demand remains lacklustre. On the other hand, if tomorrow’s Eurozone flash PMI readings show that the region is teetering on the verge of contraction, the market’s complacency could quickly evaporate and the euro-dollar could see further weakness testing the key $1.3500 support as the week comes to a close.