The Crisis Of Confidence In The EU

The European Union (EU) received a double blow, first by a French "no" on May 29 and then followed up in "no" to the Netherlands on 01-Jun. To add insult to injury, one low level Italian diplomat quickly called for a referendum in Italy to decide if it justifies a return to the lira. In addition, Prime Minister Tony Blair, who assumed leadership of the EU on 01-Jul, indefinitely postponed the British referendum on the EU Constitution. This news, along with a lot of speculation about the impact dominated international headlines for much of June. Not surprisingly, all the fuss about the EU had a direct impact on the FX market.

The euro fell to new lows seventh month after the French vote, reaching a low of 1.2371 and the "single currency has been under pressure since then. Probes below the 1.2000 level were seen before 30 June, suggesting lower short-term potential towards 1.1756 and beyond. Since the creation of the euro in 1999, central banks, especially those in Asia and the Middle East saw the diversification of dollars into the euro. Not only sought to reduce their substantial dollar holdings in the face of a declining market, but also sought the higher yields available in the euro area. However, the yield of deposits in the euro zone fell below the U.S. in December and the chain of the Fed raising interest rates bodes well for spreads to widen further.

Combining the best yields in the U.S. and an overview of the dollar generally more favorable with the specter of continued political instability in the EU and it seems that there is little incentive to hold euros at this point. Indeed, the EU faces some major obstacles long before the double "no" confidence derailed.

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