Fundamental Outlook for Euro: Bearish

- Euro-Zone manufacturing and service sectors contracted further in November, with the composite PMI reading falling to 38.9
- Retail sales dropped 0.8% in October as consumers as consumers retrenched as the region enters a recession.
- ECB cuts benchmark rate by 75 bps, as the regions second reading of 3Q GDP at -0.2% confirms a recession

Despite a week of significant event risk the Euro ended the week relatively unchanged as it traded in a narrow 300 pip range. The lack of volatility was surprising considering the fact that the ECB cut interest rates by 75 bps, which was the biggest since the single currency was instituted. The economic calendar also confirmed that the region had entered into a recession as the second reading of GDP printed at -0.2% and the manufacturing and service sectors contracted to the lowest levels on record.

Although markets are still pricing in over 130 bps of rate cuts by the central bank over the next twelve months, President Trichet in his post rate decision remarks refused to give any indication to future policy decisions. However, the MPC leader would acknowledge that the upside risks to price stability had alleviated allowing for the aggressive policy decision. The committee would lower their inflation expectations for next year to between 1.1% and 1.7% which is below their 2% target. Policy makers also believe that growth will be between -1% and 0 for 2009 as growth risk are firmly to the downside. President Trichet would go on to point out the fact that the central bank had decreased rates by 175 bps in less than two months, which appeared as if he was making the case that the MPC may have taken enough action in the near-term. He would also refute the notion that the economy may experience deflation as committee is forecasting a return to growth in 2010 which should lead to higher inflation expectations in the second half of 2009.

If the past week’s significant event risk failed to break the EUR/USD out of its current range then we may see it continue to trade sideways as next week’s economic calendar is filled with second tier indicators with the German ZEW reading for December providing the greatest chance of volatility. The medium-term forecast for the economy is expected to decline to -57.5 from -53.5, as growth continues to stall in Europe’s largest economy, which was evident by the 7.1% decline in domestic demand for intermediate goods. If markets start to lower their expectations for further easing from the ECB we may see the Euro look to test the upper band of the current range at 1.3000. However, if the central bank’s forecast for a return to growth in 2010 appears unattainable then they may be force to ease further.

Terri Belkas is a Currency Strategist at FXCM.