DJ Forex Focus: Still No Real Faith In the Euro

Risk taking in this market is only for the very brave.

Hopes that pressure from the U.S. may be pushing the European Union to come up with a larger and longer term rescue plan for Greece as early as this weekend has certainly lifted global optimism.

U.S. Treasury yields have recovered, global stocks have rebounded a little and even riskier currencies, such as the euro, have found support.

However, any real recovery in market appetite for risk still has a long way to go.

Even if the European Union and the International Monetary Fund come up with the EUR100 billion three-year package that many are hoping for, it would still be far too early to call an end to the crisis.

Apart from the thorny issue of German parliamentary ratification of the deal, when 60% of the country oppose helping Greece, there is also the problem that even the enlarged rescue package will be only be just enough to cover Greece's redemptions and repayments over the loan period.

Greece will still face the problem of a massive fiscal deficit in the future, and its return to global financial markets to borrow at reasonable rates is still very much in question.

As developments this week have shown, the risk of contagion to other euro-zone debtors has not gone away. If anything, this has now increased given the decision by Standard & Poor's to downgrade the sovereign debt ratings for Spain and Portugal.

As far as sovereign debt is concerned, the euro zone is not the only problem. The U.K. could well find itself next in line if next Thursday's general election fails to bring in a new administration with either the majority or the determination to resolve the U.K.'s fiscal problems.

Some analysts reckon that the only reason that the U.K. has avoided a downgrade so far is that not so much of its debt is held abroad.

All these concerns about Europe and its debts are having other negative consequences too.

As the U.S. Federal Reserve appeared to confirm Wednesday when it left its policy stance unchanged, major central banks are reluctant to start hiking interest rates at this stage of the recovery even though inflationary pressure could be starting to rise.

But, it is the sovereign debt impact on banks that is now becoming a central concern.

Signs of liquidity strains started to show for the first time this week, with the three-month European interbank rates rising to their highest level in two months.

Until now investors may have simply been switching out of Greek paper into other euro-zone paper, with little impact on the euro. However, if the risks of contagion are growing, then euro-zone paper itself may be shunned, very much to the cost of the single currency.

For European banks this means a likely increase in counterparty risk with banks unwilling to lend to each other for fear of excessive exposure to illiquid euro-zone assets.

"Although we are not yet at the extremes, current market developments closely mirror the genesis of the funding crisis two years ago, and investors will need to be on their guard," warned Gareth Berry, a senior currency strategist with UBS in Singapore.

Early Friday in Europe, sentiment towards the single currency remained positive on news that Greece has outlined a EUR24 billion austerity package and as European Commission President Jose Manuel Barroso said he is confident that an assistance package for Greece will be finalized "very soon, meaning, in the next days."

Gains remained minimal, however, with the euro only rising to $1.3268 by 0645 GMT from $1.3238 late Thursday in New York, according to EBS.

As the currency strategy team at UniCredit said: "The fact that the euro failed to climb at least back above 1.33 does not bode well for its medium-term perspectives: selling the euro into strength remains favored again."

See the weakness of the euro's bounce:

Neverthless, positive economic data from Japan as well as a signal from the Bank of Japan that the end of deflation is nigh helped to boost general market sentiment.

The euro also rose to Y124.76 from Y124.53 while the dollar edged down marignally to Y94.04 from Y94.07.

The pound rose to $1.5380 from $1.5323, helped by opinion polls showing that Conservative leader David Cameron widened his lead slightly after the final television debate Thursday night.

Bloomberg TNI FRX POV

   Reuters   USD/DJ    Thomson   P/1066 or P/1074 

(Nick Hastings has covered the foreign exchange markets and industry for over 20 years. Apart from his written commentary and analysis, he also appears on Fox Business News and CNBC television in Europe, Asia and the U.S. He can be contacted on +44-20-7842-9493 or by email: nick.hastings@dowjones.com)