THE PROBLEM WITH THE EURO IS IN THE CORE

AS CURRENCY markets opened this week in Asia, euro-dollar traders were already on edge, after the Socialists lost badly in Spain and Standard & Poor’s (S&P) downgraded Italy’s sovereign debt. In a report published over the weekend, the ratings agency affirmed Italy’s A+ long-term rating and its top-ranked A-1+ short-term rating but lowered the credit rating outlook to negative from stable. S&P pointed to slowing economic growth and “diminished prospects for a reduction of government debt”, as the primary reason for its action. The rating agency said Italy’s debt had a one-in-three chance of being downgraded in the next two years.

Italian officials quickly challenged the S&P report, with Giulio Tremonti, the finance minister, noting that “the only new element (in the report) is that there apparently is a risk of political gridlock. This is absolutely out of the question.” Meanwhile, the credit markets were far less sanguine, with credit spreads on Italian sovereign debt widening out to new highs.

Yet despite the continued focus on the political and economic problems in the periphery, the real trouble for euro-dollar could lie within the Eurozone core. This past Monday, traders got a glimpse of German PMI Manufacturing data and the news was not good. While German PMI readings remained above the 50 boom/bust level, the flash results for May printed at 58.2 versus 61.2 eyed. The data for the services sector was even worse as it came in at 54.9 versus 57.1 forecast. This was the weakest reading since October of last year, indicating that growth in the Eurozone’s largest economy is decelerating at an alarming rate.

If growth in the Eurozone’s core economies continues to slow as the summer progresses, the chance of any additional European Central Bank rate hikes will become minimal at best, even if inflation pressures remain elevated. The break below the critical $1.40 level on Monday morning indicates that markets no longer view euro-dollar as a possible yield play and, as that change in sentiment takes hold, the pair could see more selling in the days ahead.