The ECB is widely expected to keep rates on hold at 4.25%. Yet, in the near future the ECB could come under pressure from several EU politicians to review its monetary policy and lower interest rate differentials may accelerate the losses in the EUR/USD.

The ECB has been caught in a very difficult situation having to chose between slowing growth and rising inflation

Last month, annual inflation in the euro area fell to 3.8 per cent from 4 per cent in July, according to Eurostat. However, despite the recent easing on energy prices, the European Central Bank remains very concerned about price stability. To some extent, the ECB is worried about second round effects of energy prices since many employees want to renegotiate their salaries so they can afford to pay for gas prices. Nonetheless, the Governing Council of the ECB will soon come under pressure from EU politicians to review its monetary policy.

Recent economic data points towards a weakening of real GDP growth in the euro zone economy and a more accommodative monetary policy could be needed to prevent the region from falling into a recession. In fact, traders expect the ECB to cut rates by nearly 50 bps over the next 12 months, according to overnight index swaps. On the other hand, the recent sell off in commodities, particularly in oil, should alleviate some downward pressure in the U.S. economy and we expect the Federal Reserve to increase rates by almost 75 bps in the next 12 months. Lower interest rate differentials could make the euro less attractive to foreign investors and the lower level of demand for assets denominated in euros could accelerate the losses in the EUR/USD.

EUR/USD Long-Term Technical Forecast

For the first time since May 2005, the EURUSD crossed below and closed below its 12 month average. The rally from 1.1640 is most likely wave 5 within a 5 wave advance from the 2000 low at .8227 but it is still very much possible that wave 5 is in progress. Notice that RSI (13 month) and price peaked together. Major tops are almost always accompanied by divergence with oscillators (rather than convergence). The former 4th wave extreme at 1.4310 is potential support, as is the trendline at current price.

European interest rate outlook took a significant turn for the worse through recent months, and this has coincided with a similarly substantial EURUSD tumble. According to Credit Suisse 1-Year forecasts, markets expect that the European Central Bank will cut rates by a cumulative 30 basis points in the coming year, while the US Federal Reserve is forecast to actually increase Fed Funds rates by 62bp through the same period. All else remaining equal, this provides a fairly bearish bias for the EURUSD pair.

Antonio Sousa is a Currency Analyst for FXCM.