Fundamental Outlook for Euro This Week: Bearish

- Euro Zone inflation slumps to a near 10-year low 1.1 percent, clearing the way for further ECB rate cuts
- Fundamentals continue to break down for the euro, shaking the currencies subtle safe-haven appeal
- Forecasts steadily worsening for Europe as growth outlook dims, policy efforts come up short and government debt is cut

Next week, there are a top-tier economic indicators scheduled for release; but among them only the European Central Bank’s (ECB) rate decision has the potential to fundamentally redefine its currency’s trend. Looking back only six to eight months ago, FX traders were pushing the euro higher on the belief that the Euro Zone would be able to ride out the financial and economic contagion that was spreading beyond the US boarders. What’s more, there was the implicit belief that the region’s yields would remain a beacon for investors looking for safety of funds with the kind of returns that traders had become used to through 2007. How things have changed. Much of this optimism has been wrung out of the euro; however, the currency is still not on even ground with the US, UK and its other major counterparts. Interest rates offer the best method to either validate or dispel these lingering doubts.

It is clear at this point that global interest rates are steadily heading towards a zero interest rate policy (with a number of notable economies already hitting this mark). This is an equalizing trend – one that has blatantly leveraged the demand for a safe haven and tipped the scales of risk / reward. And, in the panicked search for safety of funds, investors have targeted the depth and historical precedence that the US and Japanese markets; while European assets have been stung by being behind the global recession curve and through a lack of confidence in the young monetary union. However, the tables could turn. Should the European policy authority, ride out the rest of the economic slump (as a natural economic cycle it will eventually find a level of equilibrium) by holding their interest rates at a premium to global counterparts; forward-looking speculators will once again find the strength in the euro. In this capacity, Thursday’s rate decision could either signal the bank will maintain its pace of easing and possibly bring its primary cash rate near zero in a few months time; or officials can break stride by keeping policy unchanged and indicate their intentions to maintain the economy’s rate advantage. Why is there such heavy debate over their next rate decision; primarily due to ECB President Jean Claude Trichet’s comments at the last announcement (and later reiterations) that the next ‘important’ decision would be March’s. This has led many to speculate that the group will hold in February to wait for updated growth and inflation forecast figures in March. However, these comments may have been referring to the importance in economic data rather than the potential for policy actions. Regardless, the outcome of this meeting will be critical, especially with EURUSD and EURJPY (risk sensitive pairs) on the verge of major technical breakdowns.

At the same time, it is very unlikely that the euro will remain still while it awaits a resolution on interest rate speculation. Indeed, there is plenty of scheduled and unscheduled event risk outside the policy meeting that will help fundamental traders bide their time – and perhaps redefine their long-term fundamental forecasts. On the docket, traders will be watching retail sales numbers from both the Euro Zone and Germany, as well as factory activity figures. Outside of the neat world of foreseeable risk, market participants will also be on edge looking out for any additional sovereign debt downgrades among its members as well as announcements of expanded stimulus and bailout activity.

Jamie Saettele is a Technical Currency Analyst for FXCM.