Today, the Governing Council of the European Central Bank lowered its benchmark interest rate by 75 bps to 2.5%. In the press conference given by Jean-Claude Trichet, the President of the ECB said inflation pressures are diminishing due to a fall in commodity prices and a significant slowdown in economic activity. In addition, for the first time since the inception of the euro, the ECB predicted a 0.5% contraction of the euro-zone economy in 2009.

Euro/Dollar Forecast For 2009

It is always difficult to make exchange rate forecasts, particularly when the currency market is very volatile. Even so, in this article we argue that a considerable deterioration of the euro zone economy in 2009, could lead to a significant shift of interest rate differentials in favor of the U.S. dollar and keep the EUR/USD under pressure over the next few months. Indeed, recent economic data points toward weakening of real GDP growth in the euro zone economy and a more accommodative monetary policy by the European Central Bank could be needed to prevent the region from falling into a much deeper recession. On the other hand, the recent sell-off in commodities, particularly in oil, should alleviate some downward pressure from the U.S. economy which has been running a current account deficit of nearly 5 percent of the GDP.

The ECB Underestimated the Size of the Financial Crisis

The biggest housing and credit bubble in history continues to threat the entire global financial system and the once resilient Euro zone economy is slowly succumbing to tight credit conditions and a slowing global economy. Initially, European policy leaders thought the financial crisis would be confined to the United States and the ECB was slower to act than the Federal Reserve. Inflation in the euro zone was well above a level consistent with price stability and the ECB was concerned with second-round effects of energy prices in wage and price setting. However, the credit storm that began in the U.S. end up affecting the euro zone and European banks were forced to write off $229 billion out of a global total of $588 billion in losses related the collapse of the U.S. subprime market. While no one can deny that Jean-Claude Trichet, the ECB president, has done a lot to boost the euro as a credible alternative for the U.S. dollar, it is also becoming clear that the ECB perhaps underestimated the size of the financial crisis by keeping interest rates too high for too long. In fact, the euro zone is now in a technical recession and facing the most serious test since the euro was introduced to the world financial markets in 1999.

Risks for This Trade

In 2008, the U.S. dollar appreciated against several of the world’s most heavily traded currencies. To some extent, investors were reluctant to take leveraged positions on higher yielding currencies and the U.S. dollar was helped by a strong demand from financial institutions seeking a safe-haven currency. However, holding a long position in the U.S. dollar also involves some risks. In fact, the U.S. economy is likely to continue to face substantial challenges in 2009 including further job losses and a rapid deleveraging in the financial sector. In addition, some investors are concerned with the fiscal impact of the rescue plan which could cost almost 5 percent of GDP. Currently, the United States federal government runs a deficit of $438bn, or 3 per cent of gross domestic product and the bailout plan could push the fiscal deficit next year to $1 trillion or 7% of GDP.

Jamie Saettele is a Technical Currency Analyst for FXCM.