Why Trouble's Brewing for the Euro

Susanna Fieramosca Naranjo | E+ | Getty Images

Just when you thought the euro was safely on an upward trajectory, things are getting interesting again.

Minutes from the Federal Reserve's latest policy meeting, released Wednesday, showed that some policymakers have their doubts about keeping to the current schedule for ending the Fed's bond-buying stimulus efforts. That sent the dollar soaring against any number of currencies, including the euro.

Then there is the Italian election this weekend. Italy does not allow polling this close to voting, but the latest surveys showed former Prime Minister Silvio Berlusconi cutting his chief opponent's lead in half, thanks to stunts like adopting a homeless puppy and sending official-looking mail to Italian voters promising to reimburse payments made under new property-tax laws.

The prospect of the free-spending, freewheeling Berlusconi regaining power has German officials warning of dire economic consequences for Italy, and it's unsettling investors.

Downbeat economic reports from the euro zone are adding to the weight on the euro. The latest Flash Euro Zone Services PMI survey pointed to ongoing weakness overall. And in the north - generally in much better financial shape than the south - France has said it will overshoot its deficit target, and business activity shrank more rapidly than it has in almost the past four years.

In case all that is not enough, Jens Nordvig, global head of FX strategy at Nomura Securities, has been examining capital flows to and from the euro zone, and he says it doesn't look good for the euro. Euro zone-based investors are less worried about a disaster in the currency bloc, so their risk appetite is improving, making them more willing to send money out of the euro zone to countries with rosier growth outlooks - as the chart shows.

"The official data is always lagging. But our real-time indicators point to persistently strong outflows from the euro zone," Nordvig says. "This is the kind of stuff, which makes a sustained rally in EURUSD unlikely in our view."

Just how low can the euro go from here? Opinions vary.

Camilla Sutton, chief currency strategist at Scotiabank, says that on top of the various longer-term risk factors, there is also the event risk of an upcoming repayment of part of European banks' refinancing from the European Central Bank. In addition, she says, "technically, EUR is notably weak, having generated sell signals in most short-term studies."

Kathy Lien, managing director at BK Asset Management, is also edgy. She points out that a senior Standard & Poor's official has warned that Spain, France, Italy and Portugal could all be downgraded this year. "If this week's economic reports and European Commission's growth forecasts suggests that this risk has increased, then the euro could be in big trouble," she wrote in a note to clients.

Lien is watching the European Commission forecasts and the Italian elections, says that if either one goes against the euro, "the euro could resume its slide towards 1.31."

Steven Englander, global head of G10 FX strategy, thinks the euro could move lower than that. The market, he told me, "may be slightly long EUR and has been ignoring political and economic issues till the last day or two." He thinks it could trade below 1.3000 if two of three factors look negative: economic data, political events, or bond auctions.

In his view, he told me, "euro pricing still reflects more good news than bad."

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