Euro seen falling as Europe faces recession

Stacks of Swiss franc, Euro and U.S. dollar banknotes are displayed in a bank in Bern August 15, 2011.

NEW YORK (Reuters) - It has been a rough start to 2012 for the euro and it won't get any easier next week as the region grapples with a possible recession and two of its larger economies conduct a crucial test of investors' appetite for their debt.

In the first week of the year the euro has lost 1.8 percent and 1.6 percent of its value versus the safe-haven U.S. dollar and yen, respectively. The losses were largely driven by a growing contrast between the recovery in the world's largest economy and Europe, which is widely believed to be either in, or headed toward, a recession.

Data showing a healing U.S. labor market helped send the euro to a near 16-month low against the dollar on Friday and more losses are likely if euro zone sovereign debt and bank funding issues stay unresolved.

The market is seen staying on edge and the euro under pressure ahead of Italian and Spanish government bond sales next week, viewed as the year's first big fundraising tests for struggling euro zone countries.

"The euro will likely continue to fall next week," said Charles St-Arnaud, forex strategist at Nomura Securities in New York.

Investors are particularly concerned about the borrowing costs of Italy, which must pay out 100 billion euros in bond coupons and redemptions in the first four months of 2012 alone.

Yields in Italy and Spain have continued to increase since the beginning of the year, with Italian 10-year yields back close to their end-November level, St-Arnaud said.

"Strong auctions could provide some support to the euro, but with the focus gradually turning to economic weakness and its impact on the fiscal situation, the support could be short-lived."

Nomura Securities said Friday's robust U.S. nonfarm payrolls report added to a string of recent information that increased the firm's conviction that the euro is on track to reach the firm's $1.20 target in the first quarter.

As Europe's economy remains weak, the European Central Bank could decide to initiate measures to stimulate growth through asset purchases or another interest rate cut, or both.

Asset purchases would flood the market with euro supply and is therefore tantamount to printing money, which dilutes its value. Unfavorable interest rate differentials make higher-yielding currencies more attractive than the euro.

While strong economic data in the past buoyed risk appetite and benefited the euro, the divergence between the economies in the United States and Europe has investors embracing the greenback.

"This implies that markets are beginning to price euro risk as euro-centric and no longer as a proxy for global market risk," said Camilla Sutton, chief currency strategist at Scotia Capital in Toronto.

This is an important development as it opens the door for other currencies, such as the Canadian dollar, to move more on fundamentals, she said.

"The euro is in the midst of taking another leg lower, a move that is coming as the market is forced to re-price euro-centric risks."

In late afternoon New York trade, the euro was 0.5 percent lower against the dollar at $1.2718 after hitting a low of $1.2696, its weakest since September 2010, according to Reuters data.

Currency speculators reduced their bets in favor of the U.S. dollar in the latest week but bolstered short euro position to record levels, according to data from the Commodity Futures Trading Commission released on Friday.

The euro has also decoupled with risk reversals, suggesting option traders are easing back on their desire to protect against dollar upside, Scotia's Sutton said.

"However, this is likely because most are already short euro and because of shifts in proxy hedging for U.S. equity hedging. The breakdown in correlations is an important theme for 2012, and one that will likely weigh heavily on the euro."

The euro's drop helped buoy the dollar to a high of 81.376 .DXY against a basket of currencies, its strongest since late November, 2010. The dollar index was last up 0.4 percent at 81.264.

The euro was 0.7 percent lower against the yen at 97.96 yen after touching a low of 97.88, its lowest since mid-December 2000, according to Reuters data.

As well as next week's debt auctions, the market will await a meeting between French President Nicolas Sarkozy and German Chancellor Angela Merkel on Monday for fresh hints on steps they may take to try to resolve the EU debt crisis.

The U.S. currency fell 0.2 percent against the yen to 76.98 yen but remained off the trough touched this week which was the lowest since mid November using Reuters data.

(Reporting By Julie Haviv; Additional reporting by Nick Olivari, Gertrude Chavez-Dreyfuss and Steven C. Johnson; Editing by James Dalgleish)