Fundamental Outlook for Euro: Bearish

- ECB President Trichet’s comments prepare market for further easing at November 6th meeting
- Business and consumer confidence plunge as financial crisis spreads to the economy
- Is inflation cooling fast enough to encourage the ECB to lower rates without CPI at target?

The euro was able to reclaim some of its losses against the benchmark dollar last week, but was this a genuine trend change or a mere bounce? That question will likely be answered by the ECB this coming Thursday. European Central Bank rate decisions are frequent market movers -- despite the fact that policy officials have changed the benchmark lending rate only once in regular operations over the past 16 months. However, interest rate policy around the world has certainly changed in just the past three months; and the significant speculation surrounding the ECB’s next meeting certainly leverages its influence over the wayward euro. With most of the G10 central banks having already established an aggressive pace of rate cuts, the European bank stands out as one of the few that has so far held onto its inflation convictions and kept their benchmark steady. That won’t last for long however.

Just three weeks ago, Trichet was prompted into action when he joined the Fed, BoE and SNB in a coordinated rate cut by lowering Europe’s primary lending rate 50 basis points to 3.75 percent. This set the wheels in motion; yet there is still a question of how dovish their policy efforts will be going forward and even if further cuts are on the table. Overnight index swaps show the market is pricing in a rather significant pace of easing on forecasts of nearly 150 bps expected to be shaved off by this time next year. This means that if the benchmark is lowered by only 25bps (or none at all), then the euro will be considered undervalued. Alternatively, an inline cut would validate the euro’s descent; but traders would need to see the potential for further dovish moves down the line. This will come from the statement that follows the announcement at 12:30 GMT. At the beginning of this week, Trichet foresaw scope for a cut at the upcoming meeting. Language that is clear and easily interpreted as dovish like this will be vital for reviving the currencies steady decline.

The remaining, European event risk scheduled for release next week is second tier at best; and the speculation preceding Thursday’s rate announcement will further dampen activity. On the other hand, we shouldn’t simply expect quiet markets as the clock counts down to the announcement. While volatility has pulled back recently, there is still considerable valuation risk on the euro’s part where the financial crisis and economic slowdown are concerned. European banks have just begun to falter under the credit crisis; and we haven’t even seen the second and third round effects on the consumer yet. A more certain concern is that of the oncoming recession. The regional economy contracted through the second quarter and it is expected that an official recession will be defined by the third quarter report due for release on the 14th. At this point, traders are wondering how quickly the economy will recover relative to its global counterparts and where rates will be when the upswing begins.

David Rodriguez is a Currency Analyst at FXCM.