Fundamental Outlook for Euro: Bearish

- Euro Zone policy makers commit over 1.1 trillion euros to bring an end to the financial crisis
- Investor confidence nears record low as lending and capital markets seize
- Though well above the ECB’s target, slowing Euro Zone CPI broadens the scope for follow up rate cuts

The past week was riddled with comments and data that suggests Euro Zone growth and interest rates will deteriorate faster than market participants had initially expected. This balance will be the primary concern for fundamental traders over the coming week – barring any unforeseen bank collapses or broad seizures in overnight lending. Over the next few weeks and months, traders in all markets focus will be on the effectiveness of European and other nationalized bailout efforts. Late to the game, officials from the largest member economies took sweeping and dramatic steps last weekend to extinguish ballooning fears and revive counterparty confidence to revive borrowing and investment. However, aside from a vow by ECB President Trichet to offer unlimited short-term funds to banks, most of the endeavors by policy officials have been domestic – an ineffective approach for a collective economy whose banks cross boarders. By Trichet’s own admission, it will be “up to all market participants and institutions to take the measure of what is done by the authorities.” Should traders and/or banks realize the credit bubble is far from deflated, we will once again see how quickly panic spreads and what else policy officials can do to stem the tide.

Though fear is an all consuming emotion for a trader when capital is on the line, the next concern is returns. Should volatility settle it will merely expose the euro to speculation on growth and interest rate expectations – the primary pricing tools for currency traders. Just a month ago, the euro was considered one of the few currencies that would be able to hold its interest rates at its relatively high 4.25 percent yield. That all changed however when European banks began to fail and the monetary authority was forced to cut the benchmark by 50 basis points. On the other hand, there may still be skepticism in the market that Trichet and company won’t follow up on this extraordinary move – and this is where the next leg of the larger bear wave will come from. Overnight index swaps measured by Credit Suisse suggest there is a 100 percent chance that the central bank will cut by another 25 basis points on November 6th. Economists on the other hand, believe the fight against inflation will keep the benchmark lending rate at 3.75 percent.

Another burning issue for the euro is the outlook for growth. Speculation over the severity and length of a Euro Zone recession will be held up to forecasts for all of the economy’s major counterparts; and the currency will derive its direction from this relation (the same comparison holds true for interest rates in the stead of growth). The economic docket will fuel this valuation with leading sector readings. The advanced readings of manufacturing and service sector activity for October are expected to lows not seen since the euro started trading. With the European economy already one step into recession, this figures would merely further fears that confirmation in inevitable from GDP numbers next week.

John Kicklighter a Currency Strategist at FXCM.