The euro fell to 10-week lows against the dollar on Tuesday, shedding more than one percent as a report by Moody's ratings agency fanned concern that a sharp downturn in eastern Europe would hit western European banks. Moody's said the recession in emerging Europe was likely to be more severe than elsewhere and would put financial strength ratings of local banks and their Western parents under pressure.
The euro was hardest hard by increasing worries about the prospect of a deep and prolonged recession in eastern Europe because banks from the eurozone have some of the heftiest exposure to the region. Gloom about the global economic outlook fuelled broad dollar gains, driving the US currency's trade-weighted index to two-month highs as investors sought perceived safer assets.
"There is a lot of debt held by western European banks which is denominated in eastern European currencies and the market is now beginning to appreciate it," Bank of New York Mellon currency strategist Neil Mellor said. "A lot of bad news is already priced in for the dollar and sterling, but not for the euro," he said, adding that sentiment on the eurozone is "rock bottom at the moment".
Data showing a surprise pick-up in the German ZEW sentiment survey in February gave the euro only a very brief lift, with investors remaining pessimistic on the outlook for Europe's largest economy. At 1231 GMT, the euro was down 1.3 percent against the dollar at $1.2616, according to Reuters data. That was just shy of an earlier low of $1.2602 hit on trading platform EBS, its weakest since December 4.
The dollar index was at 87.515. Earlier in the session, it rose as high as 87.685, its highest in more than two months. "The market cannot get to the point where it gets more confident. That being the case it keeps coming back to the dollar and I don't see that changing," BNYM's Mellor said. Markets remained averse to risk, with European stocks falling 1.4 percent to two-week lows.
This helped the Japanese yen gain against most currencies due to its safe haven status, although it fell against the dollar after Japan's finance minister said he would resign. Against the yen, the euro fell 1.1 percent to 115.87 yen, while the dollar edged up 0.2 percent to 91.86 yen, having earlier risen to a one-month peak of 92.75.
The ZEW economic sentiment indicator jumped in February, to -5.8 in February from -31.0 in January, significantly higher than the consensus for a much smaller improvement to -28. The improvement was not reflected in the current conditions index, however, which worsened to -86.2 from -77.1.
"February's sharp rise in the German ZEW index is modestly encouraging, but does not mean that the economy is about to stop contracting sharply," Capital Economics European economist Jennifer McKeown said in a client note. Meanwhile, growing expectations that the European Central Bank will ultimately have to play catch up on rate cuts by the Federal Reserve and Bank of England also weighed on the single currency.
Figures derived from Eonia rates show the market is expecting eurozone interest rates will be cut to 1.5 percent in March and fall below 1.0 percent later this year. "All other central banks in the G10 have frontloaded cuts one way or another and are openly discussing aggressively adopting unconventional measures," said UBS strategist Geoffrey Kendrick in a note. "We believe the ECB's refusing to consider other options will continue to cast the eurozone in a negative light and sentiment on the euro will suffer accordingly."