Market Overview

Euro Edges Higher against U.S. Dollar despite Mounting Concerns over Debt in Italy

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The euro edged higher against the U.S. dollar on Friday, despite mounting concerns that Italy's debt burden is becoming unbearable. Presently, the euro trades around $1.4135, or 0.28% above its previous close. At the same time, the euro is retreating against the Japanese yen. The yen is fighting back after the Bank of Japan intervened on Thursday in order to weaken the Japanese currency. At the moment, the euro surrendered 0.23% of its value to stand around ¥110.92.

Italy is increasingly becoming the main battleground for the survival of the Eurozone. As the Eurozone's third largest economy, Italy might be too big to fail, but it is equally too big to bail out. If the Eurozone is to survive, at least in its current form, Italy will need to avoid the fate of Greece, Ireland and Portugal.

Reasons why Italy is being targeted by investors are obvious. Italy's debt burden is 120% of GDP, second highest in the Eurozone after Greece. In fact, Italy accounts for 23% of the entire Eurozone sovereign debt. This, in turn, means that Italy has to go to the bond market on a regular basis in order to finance its debt. In the second half of the year alone, Italy will need to raise around €273 billion. With investors asking for ever higher yield in order to be persuaded to buy Italian bonds, it is no wonder the European political elites are anxious.

If Italy is to survive, its sluggish economy will need to recover. However, the latest industrial production data makes a strong rebound in the Italian economy highly unlikely, at least in the short run. According to Istat, Italy's industrial production declined 0.6% in June, compared to the previous month, while most analysts had predicted a 0.2% increase. In May, industrial production also fell by 0.6% month-over-month. On an annual basis, the June figure was 0.2% higher than in June 2010. However, this is a sharp slowdown from 2% recorded in May and 1.7% expected by most analysts.

The situation is deteriorating in Spain as well. On Thursday, the troubled Eurozone member was forced to agree an interest rate of 4.813% in order to sell €3.3 billion worth of bonds, much above the 4.037% rate investors demanded in early June. In addition, Spain postponed its next debt auction for September, in hope that markets will calm down by then. Debt problems are not the only link between Spain and Greece. Spanish protests, which have been going on for months, have suddenly turned violent on Thursday night as more than 20 people have been injured.

Prime Minister Zapatero's government has seen its popularity plunge since the crisis erupted. After a devastating defeat suffered by his Socialists in the regional and local elections earlier this year, PM Zapatero has called early elections. The opposition is widely tipped to come on top, but some analysts might fear that the ruling Socialist might leave all the unpopular reforms to the next government. In reality, this means that Spain will lose around half a year by not implementing any of much needed reforms.

It is not only public sector that is struggling with debt. On Friday, Royal Bank of Scotland (NYSE: RBS) reported losses of £1.4 billion in the first half of the year. The announcement came after the French giant Societe Generale (SCGLY) has seen its profits slump due to the writedown on the Greek debt. The Europeans have demanded that the private sector bares some of the costs of the second Greek bailout. It remains to be seen if this will destabilize the financial markets. To ease fears, the ECB has said it is prepared to give more loans to the troubled banks. As the Greece losses hit banks' balance sheets, there is bound to be many candidates for the ECB loans.

The Eurozone debt problems is a source of concern for China and Japan as well, as the two countries asked for a global cooperation in fighting the ongoing crisis. The Asian giants are worried that the financial problems in Europe and the United States might spread to Asia. In addition, both China and Japan are major exporters, and the health of their economies depends to a great extent on the willingness of the Europeans and Americans to spend. If debt woes continue, it is likely that consumers in Europe and the United States will start to tighten their belts, hurting Japan and China in the process.

ACTION ITEMS:

Bullish:
Traders who believe that the Italian economy will pick up soon, helping the government to reduce its debt, might want to consider the following trades:

  • EUR/USD Exchange Rate ETN (NYSE: ERO) is a long play on the euro. ERO may rise if the euro appreciates.
  • ProShares Ultra Euro ETF (NYSE: ULE) is another long play on the euro. However, ULE should rise more than ERO if the euro appreciates.

Bearish:
Traders who believe that the Italian debt burden is too big to be handled, which would make the survival of the Eurozone very difficult to achieve, may consider an alternate positions:

  • ETFS Short Euro Long US Dollar ETC (Sterling) ETF (SEUP) is a short play on the euro. SEUP may rise if the euro depreciates.
  • ProShares UltraShort Euro ETF (NYSE: EUO) is another short play on the euro. However, EUO should rise more than SEUP if the euro depreciates.

Neither Benzinga nor its staff recommend that you buy, sell, or hold any security. We do not offer investment advice, personalized or otherwise. Benzinga recommends that you conduct your own due diligence and consult a certified financial professional for personalized advice about your financial situation.

 

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