The euro fell on Tuesday to its weakest level versus the U.S. dollar since July 2010 on Spain's soaring borrowing costs and expectations more spending will be necessary to support its ailing banks.
The euro's losses accelerated after Egan-Jones Ratings cut Spain's credit rating yet again. Tuesday's move was the small firm's third downgrade of the country's sovereign debt in less than a month as Spain's weak banks continue to worry investors.
Spanish bond yields held near peaks in Tuesday's trading. The spread between Spanish and German government bond yields hit its highest since the euro was launched in 1999 after a government source said Madrid will recapitalize nationalized lender Bankia by issuing new debt.
"All eyes are on Spanish borrowing costs now. We're stuck in a $1.25-$1.2640 range, which suggests everyone who wants to be short the euro is already short," said Kathy Lien, director of currency research at GFT in Jersey City.
"The next catalyst could come from a rise above 7 percent in Spanish yields, which would accelerate selling. But if not, we could see some consolidation."
Investors' Europe-sensitive nerves contributed to the sharp drop in the euro on the Egan-Jones news, taking the currency below the psychologically important $1.25 level. It managed to claw back some ground by late New York trade to $1.2505, still a loss of 0.28 percent on the day. The session low was $1.2461 on Reuters data, the weakest since July 1, 2010.
The next downside target lies around $1.2450, where traders reported stop-loss sell orders and option barriers.
The euro recouped some ground against the yen but still traded down 0.28 percent at 99.35 yen. It had earlier dropped to 98.91 yen, the lowest since January.
The dollar gyrated around the break-even point against the yen. It last traded unchanged at 79.45 < JPY=>. Still, that is not far from a recent three-month low of 79.002 yen set on trading platform EBS. The pair briefly slipped after data showed U.S. consumer confidence unexpectedly fell to its lowest level in four months.
Against the Swiss franc, the dollar climbed to a 15-month high of 0 .9633 and was last up 0.19 percent at 0.9599 franc.
Earlier, the single currency found support after Greek polls showed more strength for pro-bailout parties ahead of the country's election on June 17, easing fears that Greece may leave the euro zone. But the gains were also short-lived.
Many traders expect further downside in the euro as they fear troubles at Spanish banks, hit by a property slump, could further complicate Madrid's efforts to rein in its debt.
Spanish 10-year bond yields hovered at 6.47 percent. A level of 7 percent is seen as a tipping point. Euro-zone countries that have previously requested bailouts did so soon after their 10-year yields rose above that mark.
"The bad news just keeps coming, and if Spain were to ask for a bailout, we would see the euro come under more pressure," said Steve Barrow, head of G10 currency research at Standard Bank.
"The euro remains a currency that is sold at every opportunity. We have revised our three- to six-month forecasts down to $1.15 from $1.20 earlier."
Spain's fourth-largest lender, Bankia, has asked for a bailout of 19 billion euros, in addition to 4.5 billion euros the state has already pumped in to cover possible losses on repossessed property, loans and investments.
Prime Minister Mariano Rajoy has ruled out seeking outside aid to revive Spain's banking sector, but many investors are skeptical that the country's lenders can be recapitalized without external funding.
Most economists believe that Spain's banks will need outside financial help.
"The point about Spain is it's going to need some external support of some form," said David Owen, chief European financial economist at Jefferies.
"Whether that implies the European Central Bank buys bonds (in the secondary market) or moves lock, stock and barrel to quantitative easing over the next three months, certainly the situation at the moment is not sustainable."
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