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Tuesday May 11, 2010 - 13:18:24 GMT
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Euro Erases Gains as Bailout Euphoria Wears Off

The U.S. Dollar is trading higher overnight against most major Forex markets, buoyed by two major events: the inability of the European Union’s rescue package to instill investor confidence in the Euro and the news of the resignation of U.K. Prime Minister Gordon Brown. Both events are driving traders out of risky investments, triggering an increase in demand for lower risk currencies.


After a one day reprieve following the announcement of the European Union’s $1 trillion bailout package, the Euro is once again in a free fall this morning, threatening to take out the recent bottom at 1.2518. The historic announcement by the EU over the week-end failed to generate enough investor confidence to support the Euro, but more importantly reaffirmed that the destiny of the Euro is clearly in the hands of the hedge funds and large traders.


The fact that the Euro is trading sharply lower ahead of the New York session is a strong sign that the euphoria of the past 24-hours is over and that reality has returned to the Forex markets. Simply stated, Monday’s trading action demonstrated that traders accepted the fact that the EU’s aid package was a short-term fix and that over the long-term the economic problems in the Euro Zone would continue to exist long after the new money was sucked into the financial system. The post-bailout package sell-off in the Euro is also serving as proof that the market doesn’t believe that a country solves a debt crisis by issuing more debt.


The rejection by the market of the rescue plan serves as notice to the EU community that there is little doubt that the only way to avoid the spread of contaminated debt in the Euro Zone is to implement further austerity measures rather than pile debt upon debt. The overnight weakness in the Euro is also a strong indication that the market is discounting the inevitable that the debt of Greece, Spain and Portugal is getting very close to being declared “junk” by the credit rating services.


Besides the fear of contagion over the short-run, Euro investors are dealing with the real possibility that the bailout package will be a drain on European economic growth. The implementation of the unprecedented bailout package means that resources will be used to fill in “holes” in the economy rather than sow the seeds for future prosperity. Flooding the market with excess liquidity will force the European Central Bank to keep interest rates low for a longer period of time. As other major central banks begin to withdraw stimulus and hike interest rates, investors will shift investments out of the Euro Zone and into these higher yielding currencies putting additional pressure on the Euro.


While Euro investors deal with contagion issues, British Pound investors are wondering what happened to the government. The decision by U.K. Prime Minister Gordon Brown to quit has created disarray in the government just 5 days after the recent election resulted in a hung parliament.


Speculators are selling the British Pound this morning while the three main political parties haggle over how to structure the new government. At this time the Labour Party and the Conservative Party are trying to gain control of the hung parliament. The main objective of the process taking place at this time is to convince the Liberal Democrat party to throw its support to one of the two strongest parties.


British Pound traders are taking no chances at this time that a solution will be reached soon. Instead they have decided to sell the currency now and ask questions later. Even if a government is created today, the U.K.’s financial woes are not expected to disappear. There is still the main issue of how to balance the budget and reduce the country’s debt load.


The longer it takes to form a government, the more impatient traders will grow. This means that downside pressure is expected to continue until the new government issue is settled. Furthermore, the delay in producing a government could lead to a downgrade of the U.K.’s debt rating as the credit rating services will interpret this to mean that a solution to its debt problems may be difficult to attain in the short-run.


Today, traders should watch for a reversal of the action on Monday. In other words, risk adverse traders are expected to sell higher risk assets while seeking shelter in the lower yielding currencies. Look for downside pressure on the commodity-linked currencies. Overnight, traders are driving the Australian Dollar, Canadian Dollar and New Zealand Dollar lower. At the same time, the lower yielding Japanese Yen is rising versus the U.S. Dollar.





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