Euro Slide Could Be Preview of a Troubled New Year

The euro’s dramatic slide to the year’s lows in light trading is a likely prelude to more weakening in the New Year and highlights the long haul ahead for the euro zone’sdebt crisis.

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Analysts say the euro’s fall, to a level of 1.2858 against the dollar Thursday morning, was in part due to the lack of participants in the market but also because the list of hurdles facing the euro zone remains long. The euro later recovered from its 15-month low and was trading above 1.29 in afternoon trading.

The euro fell to a decade low against the yen. As the euro recovered Thursday morning, stocks also rose, turning the S&P 500 slightly positive for the year. Gold also came off its low of $1,523 per ounce, a 20 percent decline from its September highs, which put it in bear market territory.

“I think the euro is telling us it’s a very thin market, but people are preparing for the worst next year,” said Brown Brothers Harriman chief currency strategist Marc Chandler.

Chandler said the market is looking ahead to the huge rollover of sovereign debt next year, with a total of more than $150 billion in the first quarter. Italy auctioned 7 billion euros in long dated bonds on Thursday, and the yield on its 10-year fell to 6.93 from November’s 7.56 percent rate. But in trading the yield continued to touch 7 percent, perceived by the market as an unsustainable level for Italy.

Italy alone has to raise at least another 50 billion euros in the first quarter, he said.

Chandler said there were several factors at play for the euro. “We saw money supply implode in the euro zone,” he said. M3 money supply growth, the broadest measure of money supply growth in the euro zone, was reported Thursday to have slowed to an annual pace of 2 percent in November, down from 2.6 percent in October. Economists had expected a 2.5 percent rate. At the same time, loan growth to the private sector slowed to 1.7 percent from 2.7 percent in October.

“All this money is not going anywhere. It’s not translating into loans. The banks are sitting with it. They are flush with cash and they’re not using it because they don’t know what’s going to happen next year,” he said, adding the banks need to raise 800 billion euros in capital. “They haven’t issued senior debt. Many of the banks are frozen out of the market.”

BNP Paribas strategist Mary Nicola said the two-day drop in the euro really started Wednesday morning with heavy corporate flows. “The afterthought was the market didn’t react immediately, but it later on realized that the ECB balance sheet expanding to a record high is that the ECB is in fact engaging in some credit easing,” she said.

The market also anticipates another rate cut from the ECB which cut its interest rate to 1 percent earlier this month, and that too could send the currency lower.

The European Central Bankbalance sheet rose to a record 2.73 trillion euros, after its latest program launched last week to lend banks money at cheap rates for a longer term. The ECB gave more than 500 banks loans totaling 489 billion euros in an effort to encourage lending and boost liquidity.

“The thing is there’s such big linkages between the sovereigns and the banks,” said Chandler. “In many of these countries, sovereigns and banks are trading as if they already got downgraded.”

Even as the New Year’s holiday approaches, there continues to be speculation that several euro zone sovereigns could be downgraded by rating agencies, making borrowing more costly.

“What you do tend to find is that in thin markets, trends seem to be exacerbated and the tendency is for weakness and that’s what’s happening,” said Alan Ruskin, chief G-10 currency strategist at Deutsche Bank .

Ruskin said the ECB balance sheet expansion did not cause the euro’s decline. “It’s not a causal relationship but the size of the balance sheet is indicative of euro area problems, which are associated with euro weakness,” he said.

He said the euro decline also parallels a strengthening of the dollar on better U.S. data. As for the euro, the decline could continue. “1.25 is fairly easily in sight,” Ruskin said.

Chandler said the weaker euro would be part of the solution for the euro zone, helping exports in its weakest members and its wealthiest—Germany.

What’s really going on is an attempt to cure the patient. Castor oil doesn’t taste good, but it helps,” he said.

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