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Renewed debt fears to put euro resilience to the test

The euro has remained resilient amid the turmoil that has engulfed the financial markets in recent weeks, but its fortunes might be starting to turn.

The single currency found support after Ben Bernanke, Federal Reserve chairman, warned of the possibility that the US central bank was considering tapering its quantitative easing purchases on May 22.

The resulting rise in global bond yields led to a sharp sell-off in global emerging markets (EMs), but did little to quash appetite for the euro.

In fact, positioning data from the CME show that ahead of last week’s Fed meeting, speculators were net long of the euro for the first time since February.

That meant in the space of just three weeks speculators turned from holding a substantial net short position in the single currency to a decent net long position.

 CME speculators establish long euro positions

Jane Foley, strategist at Rabobank, says the timing of the change in sentiment in the single currency suggests there has been a general unwinding of euro diversification trades in recent weeks.

Indeed, since Bernanke’s comments on May 22, all EM currencies, with the exception of the Czech koruna, have underperformed the euro.

“While this strong relative performance of the euro may be a surprise to many in view of the recessionary backdrop in the eurozone and the peppering of poor news concerning EMU, it is textbook behaviour for a currency with a solid current-account surplus,” says Foley.

“In times of uncertainty, current-account surplus currencies tend to find support.”

The unwinding of diversification trades has provided the euro with support against the bullish tone of the dollar. In the G10, the dollar has notched up striking gains against the likes of the Australian dollar and the Norwegian krone. In contrast, the euro is still higher against the dollar than when Bernanke first mentioned Fed tapering a month ago.

Still, there are some that believe the euro will not remain unscathed from the turmoil that is engulfing global markets.

David Simmonds, head of currency strategy at RBS, says after market attention has shifted from the Fed’s tapering intentions to higher global bond yields, to wider corporate credit spreads and to a liquidity capitulation in global EMs, it is the eurozone and its peripheral debt market that is likely to be the next “risk theatre” for investors.

He notes that worries over eurozone peripheral debt have been relatively subdued since the speech from Mario Draghi, European Central Bank president, last summer in which he introduced the OMT bond-purchasing scheme and pledged to do whatever it takes to save the euro.

“But [eurozone] peripheral yields are rising, and the fundamental backdrop looks threatening,” says Simmonds.

“Expect renewed questions about debt sustainability in Greece, to questions over whether Portugal will need bigger, more prolonged bailout assistance, to opacity and delays over key structural reforms, including bank bailout procedures.”

Simmonds believes a re-widening of eurozone peripheral spreads can help drive EURUSD lower over the remainder of the summer and beyond.

Indeed, the issue over the sustainability of eurozone peripheral debt is now coming to the fore as the generalized sell-off in European debt sparked by rising yields in the US is hitting markets harder in the likes of Spain and Italy.

Italy has been the focus of attention, with Italian bond yields rising to a high for the year around 4.9%. That is up from lows around 3.7% in early May, and their highest level since yields spiked after inconclusive Italian elections in February.

Part of those renewed concerns over Italy stem from a report from Italian lender Mediobanca, which warned that the country might need an EU bailout within six months – a prospect only likely to be hastened by the current price action.

Kathleen Brooks, research director at, says investors should be worried if Italian yields breach the 4.9% high from February, which could open the way for them to test the 5.5% highs seen in August 2012, ahead of Draghi’s speech.

Interestingly, she says correlation analysis suggests the issue of the sustainability of Italian debt is becoming more important to investors.

Unsurprisingly, the Euro Stoxx index has the highest negative correlation with Italian bond yields. Since the start of the year, the Euro Stoxx index had a -0.57 correlation with Italian yields, but this has surged to -0.83 in the past two weeks.

That means 83% of the time European stock markets have been moving in the opposite direction to Italian bond yields.

More crucially for currency investors, however, in the past week, the correlation between EURUSD and Italian bond yields has also surged. After remaining insignificant for most of 2013, it picked up on June 20 and is now -0.67, according to Brooks.

After lurking under the radar for the past few months, it would seem currency investors should start paying attention to peripheral eurozone debt market again.

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