Hitches in an all-in euro bet

Fresh concerns about Spain's ballooning budget deficit pushed the euro lower overnight, but while most investors expect that the common currency will only weaken further in 2012, some warn that it's far from a one-way bet.

Last Friday, Spain's new centre-right government led by Mariano Rajoy warned that Spain's budget deficit would be 8 per cent of GDP in 2011, well above the country's 6 per cent target. This would leave Spain with the third largest budget deficit in the eurozone, after Ireland and Greece.

Rajoy last week unveiled €15 billion of emergency budget-cutting measures, including €8.9 billion in spending cuts, and €6 billion in tax rises, in response to the worsening deficit. Further austerity measures are expected after a cabinet meeting on Thursday.

But overnight, Spain's economy and finance minister, Luis de Guindos, indicated the 2011 budget deficit could be even higher than 8 per cent. "It's possible we could exceed this 8 per cent number,” he said in a radio interview, "although I hope it wouldn't be by much”.

Concerns over Spain's budgetary woes weighed on the euro last night, pushing it to $US1.29 against the dollar, and to ¥99.4 against the yen, continuing the downward pressure on the currency seen in recent months.

The euro slumped during November and December, despite having performed solidly through most of 2011, as investors fretted that European politicians were failing to quell the region's worsening debt crisis. The euro ended 2011 at an 11-year low against the Japanese yen, and close to a 15-month low against the US dollar.

In recent times, hedge funds have increased their bets against the euro to a record level. They believe that growing speculation that the eurozone will ultimately fall apart will sap confidence in the common currency, and push the euro lower. Futures contracts betting that the euro will fall now represent 46 per cent of all open interest, at more than $127 billion, according to figures from the US Commodity Futures Trading Commission.

At the same time, some investors have formed the view that the US dollar will benefit if the world slides into a global recession. They argue that the US, which boasts the world's largest trade deficit, stands to benefit from a sharp slowdown in global trade.

Secondly, they argue, there will be an increased demand for the US dollars, as global business slows, and banks demand that loans (often denominated in US dollars) be repaid. The shortage of US dollars was already causing a slide in Asian and Latin American currencies towards the end of 2011.

Finally, they argue that US government bonds continue to be considered the ultimate safe haven. With Europe's debt crisis continuing to deteriorate, there is a growing likelihood that the region could face its worst financial crisis since the Great Depression in the next 12 to 18 months. As a result, global investors are likely to flock to the safety of US Treasuries, which will push the US dollar higher.

Already, the Japanese currency is benefitting from its status as a safe haven, despite Japan's own mountainous debt burden. Indeed, Japanese authorities have been forced to intervene in currency markets in an attempt to stop the surging yen from damaging demand for the country's exports.

But while most analysts are confident that the euro will continue to weaken in 2012, others warn that the break-up of the eurozone will not necessarily lead to a weaker currency.

It all depends, they say, on how the eurozone breaks up. For instance, if Greece and some of the other weak peripheral eurozone countries decide to exit the common currency, and the exit is handled in an orderly manner, then it's possible that the euro could strengthen, because it would become more like the deutschemark.

However, if the strong eurozone countries, led by Germany, decide that they have had enough and decide to quit the eurozone, it is possible that the euro could suffer a turbulent collapse.

As a result, they warn, it will be necessary to watch political developments within the eurozone closely. Because the future direction of the euro will not only depend on whether or not the eurozone breaks up, but on how any break-up occurs.