Disastrous scenarios for the euro

The risks of a government default on its sovereign debt remain high next year and the tidal wave of debt that has overwhelmed the world threatens the recent economic recovery.

A sovereign debt is debt issued or guaranteed by a sovereign issuer (usually a state or sometimes a central bank). Sovereign debt is based on the quality of issuers, is regarded as more secure than corporate debt (very creditworthy countries) or as less safe because of the virtual absence of legal recourse against the defaulting states.

The possibilities of redemption are closely related to the fiscal capacity of the issuing country, and therefore depend heavily on economic performance and good fiscal management of the country. It is from these criteria that the rating of sovereign debt is given. The debt to GDP ratio is one of the bases of assessment.

The state of public finances of Greece, whose debt could represent 125 per cent of GDP next year, has led to the agency Fitch Ratings to lower the rating of the sovereign debt of Greece from A- to BBB+, which caused a sense of fear in the markets that Greece will default on its payment obligations.

Some believe that, in the worst case, if the country found itself in default of its payments, other members of the eurozone would probably help and that the small size of Greece is not a sufficient reason to worry.

Unfortunately, reality is often much worse than the worst case scenario itself. Firstly, the small size of Greece is not a sufficient argument, as the strength of the eurozone also depends on that of their weakest link. Also, the credit rating of Greece could not be the only one to be degraded; Spain, Italy and Portugal have a debt ratio similar to that of Greece. Finally, some investors are beginning to question the possibility that some highly indebted countries are leaving the monetary union to regain the ability to devalue their currencies.

This idea has already caused turmoil in the past for the euro, especially during the failed referendum on the EU constitutional treaty in 2005, when the single currency fell from $1.3600 to $1.1600. The current nervousness surrounding the euro and the flows to the security of the US dollar should cause the currency pair EUR/USD to test at least 1.4300 shortly.

Another factor weighing on the euro is the intervention of the President of the European Central Bank Jean-Claude Trichet to prevent the bankruptcy of the sixth Austrian bank. Mr Trichet called Austrian Chancellor Werner Faymann to express his concerns about the potential impact of a bankruptcy of Hypo Group Alpe Adria, an establishment 67 per cent owned by the German regional bank Bayern LB. His involvement in this issue demonstrates persistent fears of higher authorities about the stability of the European banking system.

Upcoming FX Key events

There will be policy announcements by a number of G10 central banks this week. Data highlights include UK Retail Sales, Canada CPI (today) and German IFO (tomorrow).

FX Technical Key points

EUR/USD is bearish, target 1.4300, key reversal point 1.5150
USD/JPY is bullish, target 98, key reversal point 80
GBP/USD is bearish, target 1.5050, key reversal point 1.7000
USD/CHF is bullish, target 1.1000, key reversal point 0.9950
AUD/USD is bearish, target 0.7800, key reversal point 0.9400
NZDUSD is bearish, target 0.6200, key reversal point 0.7650

Mr Longchamp is head of trading at RTFX Ltd.

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