Fundamental Outlook for Euro This Week: Bearish

- Advanced CPI reading puts European consumer-based inflation well below ECB target at 1.6 percent
- German unemployment rises for the first time in three years – lagging the slump in general growth
- European consumer and business confidence gauges push to record lows as economy fades

In the forthcoming week, the euro may once again find a dominant, fundamental trend from its mature and wide range against the benchmark US dollar. That is because buried amid second-tier economic indicators we will receive the European Central Bank’s (ECB) first rate decision for the new year. While the policy authority’s announcements have been top economic fodder for the months, this one is particularly important as it will reveal whether President Jean-Claude Trichet and his fellow monetary policy makers will eventually take the region’s target rate to near-zero levels like its US and Japanese counterparts.

So, how can we gather this from one decision when the main rate is still at 2.50 percent? Because this decision will define the pace the ECB is willing to keep as they come dangerously close to the ever-dreaded zero interest rate policy (ZIRP). Looking to economists forecasts, a heavy consensus favors a 50 basis point cut to 2.00 percent. This would follow on the heels of the Bank of England’s own half a percent reduction this past week (though this was a significant deceleration from the clip the British policy authority had previous been running at). Interestingly enough, the market is prepared for something similar. Herein lies the potential for the euro’s strength to come under serious scrutiny. Overnight index swaps show market participants are pricing in a little more than 75 basis points worth of easing over the coming year. This would mean that the ECB would only lower rates once more and by a conservative quarter-percentage point.

However, such a move would suggest that economic activity is improving and/or inflation is a distinct danger. Neither is true. Recently, the flash estimate for CPI dropped to 1.6 percent – below the central bank’s 2.0 percent target. As for growth prospects, data continues to fade and policy makers are forecasting a deeper recession for 2009. A 50 basis point cut (or greater) accompanied by dovish language (considering the ECB’s desire for transparency) would shake hopes that the group will maintain a yield advantage over major counterparts like the US or Japan. Alternatively, should Trichet and his fellow central bankers give credible language to suggest they were at the end of the cycle (or very near it), the Euro would be considered the first currency to have found a natural turn in interest rate expectations (as opposed to merely hitting zero and having no where else to go).

It is a very important question to ask why interest rates are important considering how aggressively they have been lowered over the past year. Currently, the primary driver behind the market is still risk sentiment. The potential another event that would naturally lead to a global flight to safety still holds the market at bay. However, when investor and lender sentiment improve such that these crippling episodes are no longer a threat, risk appetite will return and idle capital will seek out the best returns (with respect to liquidity – the market won’t soon forget losses like those seen through 2008). With a European benchmark holding up yields on investable assets, there will be a premium over investments in countries like the UK and US.

John Kicklighter a Currency Strategist at FXCM.