This week the euro sold off against 11 of the world’s top 16 currencies by trading volume on speculation the ECB will have to lower interest rates to prevent the region from falling into a recession. European banks have written off $229 billion out of a global total of $588 billion in losses related the collapse of the U.S. subprime market and the credit crisis that began in the United States is now affecting the euro zone. Moreover, even though the Governing Council of the European Central Bank is widely expected to keep rates unchanged at 4.25 percent, Jean-Claude Trichet is likely to acknowledge that recent economic data points towards a sharp contraction in economic activity in the euro zone and lower interest rates could be needed to prevent the region from falling into a recession.

EU Business Confidence is at the Lowest Level since 9/11/2001

The credit storm that began in the United States is now affecting the largest trade bloc economy in the world by nominal GDP. In September, a survey done by the European Commission to companies and consumers showed that the index of confidence in the euro zone economy fell to 87.7, the worst level the 9/11 terrorist attacks in the U.S. The report showed that European consumers expect prices to rise and unemployment to stay high which could make them spend less in the last quarter of 2008. The same survey also showed that industry managers believe they may have to cut jobs in future months to remain competitive and many are making plans to invest less because of the high costs of borrowing. In fact, credit markets in Europe remain under stress and several European governments have been forced to bail out some banks to avoid any systemic risk to the euro zone economy. European banks have written off $229 billion out of a global total of $588 billion in losses related the collapse of the U.S. subprime market.

DailyFX Forecast for Euro Dollar

The recent increase in market volatility makes it very difficult to make short term predictions. Yet, we expect more EUR/USD weakness going forward and a possible test to 1.35 before the end of the year. Our main argument for this trade is that that lower interest rate differentials could make the euro less attractive to currency traders and the higher level of demand for risk free U.S. treasuries could accelerate the losses in the EUR/USD. According to overnight index swaps, which measure interest rate expectations for the next twelve months, the Federal Reserve is expected to keep rates unchanged while the ECB is expected to cut rates by 75 bps over the next 12 months. Nevertheless, there is growing speculation that any U.S. government bailout plan, whether it gets approved or not, will fail to restore investor’s confidence in the U.S. financial system and a protective spot-loss above 1.42 is suggested.

Antonio Sousa is a Currency Analyst for FXCM.