Euro call...for now

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Sterling recovered four days' losses in a single afternoon last week before proceeding to hand it all back this week. The cent-and-a-half round trip left sterling euro to open this Friday unchanged on the seven days. The euro delivered a similar yo-yo performance against the dollar but with rather more success, adding a net half cent on the week against the US currency.

As it has for several months, it was the euro that made the running as investors blew hot and cold about the Euroland sovereign debt crisis and the risk it poses to global growth and the stability of the European financial system. Last Friday they were blowing icily cold after Standard & Poor's, one of the big three American credit assessment agencies, leaked news that it would be lowering the credit ratings of certain Euroland countries. When the news was confirmed later in the day it transpired that Italy had been demoted by two notches to BBB and France had lost its triple-A premiership status and had been reduced to AA+. Altogether eight Euroland sovereign ratings were cut. Germany was unaffected, retaining its AAA grade. Although the downgrades had been well flagged, even before Christmas, their confirmation sent investors scuttling away from the euro.

After a weekend in which to reflect upon that decision, investors went back to work on the Monday with a more phlegmatic attitude. America, after all, had suffered a similar unilateral downgrade back in August and the US Treasury was still able to borrow money to its heart's content at lower rates of interest than ever before. Maybe the Euroland downgrades were not as serious as they were made out to be. And anyway, two of the three big agencies still rated France as triple-A. That perception gained traction through the week, allowing Italy, Spain and others to borrow money through the sale of government bonds at lower rates of interest instead of the higher rates that a downgrade would normally imply.

It remains to be seen, though, whether this is a fundamental change of heart towards the euro or just a temporary manifestation of crisis fatigue hitting financial markets, as can happen when investors run out of the energy to panic. If that were to be the case this current relaxation would not be the light at the end of the tunnel, it would just be one of a dozen or more low-wattage bulbs along its length.

There is still much that could go wrong for the euro, even if the International Monetary Fund does carry out its plan to more than double its rescue fund to a trillion dollars. The weakest link at the moment is patient zero; Greece. Negotiations are still going on between the Greek government, which wants to repay less than 50% of the money it has borrowed over the years, and investors who hold the bonds representing that money, who either want more than 50% or none at all. Paradoxically, many investors would be better off if Greece were to default entirely. In that case they could claim on their "credit default swap" insurance. Whilst that would protect their own immediate interests it could also precipitate a Europe-wide financial crisis. Nobody is sure exactly how such a crisis would pan out but there is broad agreement that it could get pretty nasty.

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