Euro Holds Ground despite U.S. Debt Deal

The euro is holding its ground on Monday against the U.S. dollar despite a deal being reached over raising the debt ceiling by the Washington political elites. Presently, the euro trades around $1.4407, or 0.02% above its previous close. However, the European currency is making impressive gains against the Japanese yen, rising 0.92% to stand around ¥111.53.

The two sides have finally reached an agreement to raise the U.S. debt ceiling. However, it seems the deal failed to provide steam for the greenback. Traders are not overly impressed by the agreement between the Republicans, who control the House of Representatives , and the Democrats, who control the Senate. For example, the deal does agree on a $2.4 trillion spending cuts, but these cuts will start to take effect only from 2013. Some traders might be worried that these cuts might not be implemented at all, since there is a possibility that a new president and a new Congress will be elected in the next year's election. It seems peculiar that one government agrees on reforms which will have to be undertaken by whoever wins the next elections.

Even though the political elites have avoided the worst case scenario – the U.S. default – it is still possible that rating agencies will cut the triple-A rating they currently hold on the U.S. government bonds. Lower rating will most surely translate into higher debt repayments, putting more pressure on the U.S. government finances. The rating agencies have stressed that any deal is not enough to save the U.S. from a credit rating downgrade. Instead, the rating agencies will be looking for a credible plan to resolve the U.S. debt problems. It seems traders are waiting for their response before starting to celebrate the new bipartisan debt deal.

The U.S. economy seems to be at a very fragile state, after the recent reduction to the GDP growth estimates. The latest data suggest the U.S. economy grew only 0.4% on an annual base in the March quarter, a significant reduction from the previous estimate of 1.9%. The June quarter rebound also managed to fall below expectations as the economy grew by only 1.3%, when most analysts expected the world's largest economy to expand by 1.8%.

Not everyone is pessimistic about the state of the U.S. economy. Ambrose Evans-Pritchard of Telegraph argues that there is a chance the U.S. economy is about to turn the corner. Evans-Pritchard based his claim on the rise in monetary supply, which has been a good indicator of the health of the economy in the past five years.

It is possible that the biggest winner, following the U.S. debt deal, is the Eurozone. The deal did not convince traders that the U.S. is taking decisive actions in resolving its debt problem, but a U.S. default, which will now most likely be avoided, would create chaos in the Eurozone. The U.S. debt is still viewed as the safest investment, and the U.S. default would surely change that. The probable response by traders would be to flee in panic from other risky bets, including the Italian and Spanish bonds. With Italy and Spain cornered, it is very likely that the Eurozone would have to raise the white flag.

The Eurozone periphery provided some support to the euro in Monday's trading as Italy's unemployment rate fell from 8.1% in May to 8% in June. In June 2010, the unemployment rate in the Eurozone's third largest economy stood at 8.3%. In spite of an improvement in employment data, Italy remains one of the weaker members of the Eurozone. Italy is undergoing not only an economic but also a political crisis as the embattled Prime Minister Berlusconi is facing various charges ranging from having sexual intercourse with minors to corruption. If the Eurozone is to stand a chance of surviving in its current form, the political and economic situation in Italy will need to improve quickly.

ACTION ITEMS:

Bullish:
Traders who believe that the latest deal on the U.S. debt will bring back confidence to the international financial markets, which should ease off pressure on the Eurozone, might want to consider the following trades:

• WisdomTree Dreyfus Euro Fund (NYSE: EU) is a long play on the euro. EU may rise if the euro appreciates.

• ProShares Ultra Euro ETF (NYSE: ULE [FREE Stock Trend Analysis]) is another long play on the euro. However, ULE should rise more than EU if the euro appreciates.

Bearish:
Traders who believe that the Eurozone's periphery will continue to sink, irrespective of what is happening in the U.S., may consider an alternate positions:

• ETFS Short Euro Long US Dollar ETC (Sterling) ETF (SEUP) is a short play on the euro. SEUP may rise if the euro depreciates.

• Market Vectors Double Short Euro ETN (NYSE: DRR) is another short play on the euro. However, DRR should rise more than SEUP if the euro depreciates.