Fundamental Outlook for Euro: Bearish

- Financial crisis spreading to Euro Zone
- ECB holds rates, but markets speculate a cut is inevitable
- European growth fading quickly, inflation starting to follow suit

A fundamental outlook for the euro should oddly enough begin with a look to the technicals. This past week, the pair cleanly broke below a dominant, rising trendline that began back in January of 2002 (meaning this trend has guided price action for two-thirds of the euro’s life). This shift in sentiment has certainly found its roots in fundamentals though. The biggest concern for euro traders going forward are signs that the financial crisis has spread to the Euro Zone. In just a week’s time, Hypo Real Estate, Fortis and Dexia all required government rescues to remain solvent. It may be tempting for policy makers and traders to say the turmoil in the credit markets has passed; but that could be a premature call. The initial $300 billion approved by the US Congress to aid the markets is limited to US firms. As we have seen that the problem has clearly spread, this effort may be too little, too late steady the global credit market. There have already been calls by French government officials (that were promptly debated by Germany) for a 300 billion euro rescue for Europe. If markets lending rates and capital markets disregard the US effort made last week, the calls for a Euro Zone plan will grow louder.

The other major theme for the euro next week will be rate speculation. While the ECB did vote to keep rates unchanged at 4.25 percent this past Thursday, President Trichet’s commentary took on an increasingly dovish tone. Indeed, his suggestion that, while the vote was unanimous, they did consider both holding rates and cutting them is a perceptible shift from subtle warnings of potential rate hikes. At this point, it seems policy officials just need to find the equilibrium between growth and inflation where the former generates more concern than the latter. Already, we have seen that the negative growth through the second quarter has started to weigh on inflation trends. In fact, this past week the advanced Euro Zone CPI estimate for September cooled for a second consecutive month to 3.6 percent. While this is still well above the central bank’s target rate, the downshift in growth and slowdown in the German consumer inflation gauge to 2.9 percent reveals that we are heading in the right direction. It is difficult to judge where that inflation and growth(financial market risks falls in this category) will shift in favor of rate cuts, but we can already see overnight index swaps pricing in more than 100 basis points of cumulative easing over the next 12 months. Now, the question is, will that first cut come next month?

John Kicklighter a Currency Strategist at FXCM.