Fundamental Outlook for euro This Week: Bearish

- European Monetary Union sees three sovereign debt ratings downgrades – trouble for the euro?
- Euro finds some support despite dismal Industrial data
- Euro nonetheless sees potential upside from technical standpoint

The euro lost against the US Dollar for the fourth consecutive week of trade, but a substantial rally from intraweek lows suggests that traders are thus far unwilling to push the euro/US Dollar even lower. Flare-ups in financial market tensions and well-publicized sovereign debt downgrades of three European Monetary Union member countries were the primary drivers of euro losses. Indeed, near-universal declines in European equity indices underlined material deterioration in domestic risk sentiment and financial market confidence. Major debt rating agencies added to the air of distress when they downgraded sovereign debt ratings for Spain, Greece, and Portugal. Though the moves were not wholly unexpected, they reminded traders of potential threats to EMU stability and sent the euro lower in kind.

Debt downgrades reignited fears of EMU breakup—reminiscent of stresses created by the French and Dutch rejections of the EU constitutions in 2005. Though it is obviously an oversimplification to call the situations equivalent, stresses and fears over the viability of the euro feel surprisingly similar. A number of research desks have been publishing reports on the potential for certain countries to leave the EU and/or EMU—similar to what we saw in 2005. French and Dutch rejections of the EU constitution very much undermined confidence in the viability of a common currency, and the euro fell substantially against all major counterparts through the second half of 2005. Whether or not we see something similar through 2009 remains to be seen, but continued talk of EMU breakup can only hurt the single currency.

The week ahead promises a good deal more economic event risk than the last, and it will be important to watch key reports out of Europe’s major economies. Indeed, Germany—Europe’s largest economy—will release highly-anticipated economic confidence surveys and unemployment figures for the month of January. The past week’s German ZEW data underlined the fragile state of business confidence for domestic managers, and the upcoming IFO survey will likely confirm that sentiment remains depressed. All the same it will be important to watch for surprises in the IFO survey as well as the GfK Consumer Confidence release due the next day. Thursday’s German Unemployment Change results likewise bear close watching, while Friday’s German Retail Sales report will shed light on the health of domestic consumption. Surprises out of any of these major reports could force shifts in fundamental sentiment for Germany and the broader EU.

Antonio Sousa is a Currency Analyst for FXCM.