Fundamental Outlook for Euro: Bearish

- ECB monthly report forecasts economic recession to crest in 2009
- Service sector activity contracts a seventh consecutive month, inflation cools to near-target
- Central bank announces plans to cut interest paid on back deposits, increase emergency lending rate

The euro enjoyed a strong rally this past week, but was this a sign of optimism in European growth and interest rates or a mere retracement borne from the need to quickly diversify away from the US dollar? This will be a pivotal question for the FX market’s second most liquid currency when fundamental traders come back in full force at the beginning of 2009. What’s more, sorting out the forecast for the euro may actually clarify the dollar’s path through the coming weeks. Crunching the numbers, the euro’s rally last week was the biggest since the currency began trading nearly a decade ago. However, this strong momentum was predominately reflected against the dollar and pound – the economies that have fared the worst through the ongoing credit crunch and global recession. Against the popular risk-averse currencies (yen and franc) and the high-risk units (Australian and New Zealand dollars), the euro was actually loosing ground or held relatively stable. This suggests that the euro was not taking on the title of a safe haven currency. Instead, it seems traders are just liquidating their built up dollar positions before year end and were responding to the Fed’s rate cut or the pending auto industry collapse. With the dollar tumbling quickly, investors needed a secure alternative and the euro’s deep liquidity gave the currency a leg up.

Looking out over the final weeks of 2008 and into the open of the new year, the euro’s path will depend upon the influence of risk appetite on broader investor sentiment. If the demand for a safe haven is as overwhelming as it has been over the past quarter, the euro may once again be snubbed by capital that flows into the US and Japan for risk-free government debt. On the other hand, if the market sours on these economies or if sweeping risk aversion lets up, traders may start looking to growth and interest rate potential as a market driver. In the past few weeks, rhetoric from the ECB has shifted back to neutral territory. Further commentary from bank members or President Jean Claude Trichet himself would go a long way towards securing the euro’s current 2.50 percent benchmark rate – which would be a considerable premium over most of its counterparts when the demand for yield begins to gain ground on aversion to risk.

Outside of interest rates, the fundamental forecast is certainly not encouraging; but in the currency market, strength is a relative measurement. Looking at scheduled event risk, there will be readings for both inflation and economic activity for traders to work with. Following up on the plunge in the Euro-Zone’s year-over-year CPI reading to just above the ECB’s target, the German producer price index for December will take the measure of upstream inflation that will feed through to the consumer later. Later, the docket will go straight to the heart of potential growth with the German GfK consumer confidence survey for December. If sentiment maintains its negative trajectory, there will be little hope for domestic demand to offset the void in foreign orders.

John Kicklighter a Currency Strategist at FXCM.