Euro May Keep Falling, Dragging Down Rest of Market
The euro could be headed for a long slide—and possibly take stocks and commodities with it.
The beleaguered currency skidded Monday, as the European leaders' summit failed to bolster confidence in their ability to stem the sovereign debt crisis. And with nothing on the horizon from the European Union policymakers in the near future, the currency is likely to continue to slide into the new year.
At its low Monday, the euro was down 1.5 percent at 1.3168. The euro's decline accompanied a drop in risk assets, with the S&P 500 down more than 2 percent, gold down nearly 3 percent and oil down 1.6 percent.
The euro has a tight correlation to other markets and frequently moves in tandem with risk assets, like stocks and commodities. That does not bode well for a "Santa rally," which many analysts had been expected to take the stock market higher into the year end.
U.S. stocks have acted better than European shares, as they have been responding to improving economic news in the U.S. Analysts also note that stocks could be cheered if Congress agrees to extend the payroll tax cut, estimated to be worth a half to full percent of GDP growth.
"I think we'll test 1.30 before the end of the year. The big question is are we going to stall there, or have a big clean break?" said Jens Nordvig, Nomura's global head of G-10 foreign exchange strategy.
European leaders agreed to a tighter plan of fiscal integration, including central authority over budgets and deficits.
"Now, it looks like it wasn't enough for the market," said Mary Nicola, currency strategist with BNP Paribas. "Especially the prospects of anything coming out of the ECB . It looks dimmer and dimmer."
Strategists said the market's big disappointment is that the European Central Bank is showing no signs of stepping up its bond purchases, despite the fact that ECB President Mario Draghi signaled the ECB would not expand its purchases after its rate meeting last Thursday. He had led the market to believe the week earlier that the ECB might play a bigger role if the EU leaders took action to create a stronger fiscal union.
"Everyone was hoping if there were some kind of stronger agreement...we'd see some step up in [bond] buying, and there wasn't" any, Nicola said. She said another dark cloud over the euro is the comments from rating agencies that they are reviewing the European sovereigns.
Fitch Monday said it did not see a comprehensive solution to the sovereign crisis , and it expects it to continue at varying levels of intensity beyond 2012. It also forecast a significant economic downturn across the euro zone in the near term.
The ECB is "the only truly credible firewall against liquidity and even solvency crisis in Europe," Fitch said. Moody's also commented on the summit's failure to find decisive policy measures to end the crisis and it warned it would review all the EU countries' ratings.
As risk assets sold off, spreads on European sovereigns once again widened, with the Italian 10-year again heading toward the 7 percent level.
"If we have a situation where we have the Italian bond yields heading toward 7 percent, it is going to be difficult for global markets to ignore them," Nordvig said.
Brian Dolan, chief strategist at Forex.com, said the euro hit a technical zone at 132.50 and it eventually could drop to 1.28. Nicola expects the euro to trade in its current range until the end of the year, then she too sees a move to 1.28 in the first quarter.
"Unless and until the ECB says they will use their balance sheet, the euro could go down," taking risk assets lower, said Dolan. But if the ECB does step in, the eruo could still go down. "But risk would rally," he added.
"We're now running into year end liquidity conditions so the moves can take on outsized volatility," said Dolan, adding he doesn't see the move to 1.28/1.29 until new money comes in at the beginning of the year.
Nordvig said the ECB could stop the decline if it became aggressive, expanding its balance sheet by buying up more of the debt of Europe's troubled sovereigns. The EU leaders last week also announced the earlier than expected launch of a new permanent bailout fund, the European Stability Mechanism, but markets have been looking for more buying power.
Analysts say even a verbal commitment from the ECB to buy more sovereign debt could calm down markets, and bring in sovereign spreads.
Nordvig also said the year end makes for light participation in the foreign exchange market, but a big downward move could bring players back in.
"You also have a considerable short position so that is likely to reduce the downside volatility," Dolan added.
Follow Patti Domm on Twitter: @pattidomm