Recovering Risk Appetite Won't Save The Euro Now. By Nicholas Hastings

The European Union may well have thrown the baby out with the bath water.

Fears of debt contagion may have receded and global appetite for risk may have improved but the economic costs of the emergency funding package announced last Sunday and the unexpected credit easing engineered by the European Central Bank have inflicted even more damage to the euro's prospects.

As the single currency's weak performance over the last few days has shown - global risk has decoupled and the euro is sinking largely on its own.

See the euro's latest decline against the dollar:


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As the options market shows, investors are wary. Daragh Maher, deputy head of global foreign exchange at Credit Agricole pointed out, that positions imply downside risks not seen since the time of the Lehman crisis back in 2008.

"One interpretation is that bond holders prefer the protection of buying EUR insurance in the foreign exchange options market over the more opaque insurance against catastrophe offered by EU policymakers," Maher said.

Initially, the EU's plans to provide an impressive EUR750 billion safety net along with the International Monetary Fund was taken as a signal of the determination to prevent contagion.

But, for the euro, it is now the economic implications of the package that are the problem.

Contributing countries, including Ireland, which is mired in recession, can hardly afford their share. Even Germany is going to have to forgo a long-promised tax cut and now faces severe spending cuts in order to cough up its EUR123 billion share of the deal.

So, not only will the heavily indebted nations, such as Spain, Portugal and Italy--as well as, of course, Greece--be forced into fiscal tightening but so will the region's core economies. Any hopes for a robust and early recovery from recession in the euro zone are quickly being abandoned.

News from the ECB that it would accompany this package with its own government bond purchases to provide liquidity and further reduce contagion risks produced another surprise for financial markets.

The ECB may have promised sterilization of these bond purchases but there is little sign of that, with the whole exercise being taken not only as an extension of quantitative easing but a serious reversal of the central bank's previously hawkish stance.

The move has already attracted criticism from some ECB hawks, such as Bundesbank President Axel Weber, and could well result in a sell-off in German government bunds as investors lose faith in what was once seen as a low-inflation market.

The resulting loss of credibility in the ECB could well have even more lasting damage on the euro than the current turmoil over the debt crisis itself.

Lastly, confidence that this whole exercise will stop Greece from defaulting remains as low as ever.

The government appears as unable as ever to implement the spending cuts required by the IMF. And, as Argentinian President Cristina Fernandez warned, the world has been here before.

In 2001, her country experienced the largest ever debt default after a similar dose of fiscal medicine from the IMF.

So instead of looking to a recovery, analysts are more likely to be gauging just how fast the euro will fall to $1.10 now.

Early Friday, the euro was up at $1.2567 at 0645 from $1.2521 late on Thursday in New York, according to EBS. Profit-taking that started during Asian trading appears to be the main driver for the moment, as background sentiment remains weak, with stock markets falling on disappointing results from companies such as Cisco as global recovery hopes are dented by a disappointing set of New Zealand retail sales figures and a decline in house prices.

The euro was also up a little at Y116.89 from Y116.13 while the dollar was up at Y93.00 from Y92.68.