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No respite for weary euro bulls in early European trade tonight as the battered unit hit a 19 month low against the dollar amidst rising fears that the regions economy may be severely impacted by the recent turmoil in the credit markets. Although the FX markets initially responded positively to the pan-European rescue plan spearheaded by French President Nicolas Sarkozy last week, the details of the legislation especially out of Germany suggest that the government will exercise considerable authority over the disbursement and management of the investment funds.Limitations on executive compensation, dividend policy and overall risk taking have attached a multitude of onerous conditions to government capital . The net result is that the European proposal may not provide the necessary relief to the banking sector that legislators had expected.
Indeed, with Deutsche Bank spurning any government aid, other German banks applying for the injection of capital from the government are now seen as weak by some investors and may therefore hesitate to do so. Contrast that dynamic with the current US Treasury plan which essentially forced all the major money center banks to participate in the deal eliminating the stigma while at the same time quickly recapitalizing the sector. The fears that the EZ response will create more problems than it will cure, has been the primary driver of euro weakness this week.
Although some analysts have suggested that today’s Lehman CDS settlement may be behind the rally in the greenback, many others have noted that the actual net amounts are relatively modest. Even if some of the dollar strength can be attributed to repatriation flows, the near 300 point collapse in the EUR/USD over the past 24 hours cannot solely be the result of this dynamic. The weakness in the EUR/USD despite favorable carry trade conditions indicates that the FX market is now worried that the biggest fallout from the credit crisis will happen in the 15 member union rather than US. The fear is that the region’s banking sector, which many market participants believe was even more leveraged than its US counterparts, will be slow to recover, precipitating a much deeper recession in the area than the initial analyst consensus.
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