Fundamental Outlook for Euro This Week: Bearish

- European Central Bank leaves rates unchanged, has it fallen behind the curve?
- German Retail Sales and Producer Prices hurt Euro fundamentals
- Russian debt downgrade sparks flight to safety, euro drops against US Dollar

The Euro finished the week broadly lower against the world’s major currencies, as increased stresses on Euro Zone stability and the prospects of a pronounced recession clearly cut into the currency’s fundamentals. A clear (if temporary) improvement in global risk sentiment left the Euro marginally higher against the Japanese Yen and US Dollar, but its losses against other key counterparts underline the case for further declines. Unexpectedly neutral rhetoric from ECB President Jean Claude Trichet left many doubting whether the bank was doing enough to forestall the worst economic crisis in recent times. The prospect of higher interest rates has normally been enough to boost a currency against lower-yielding counterparts, but it is clear that current times are far from normal. An especially bearish outlook for European economic growth may continue to hurt the Euro through the foreseeable future.

Euro Zone economic growth will continue to dominate headlines in the week ahead, with highly-anticipated Gross Domestic Product figures due Friday the 13th. Jokes about the ominous release date aside, the GDP figure is expected to show truly dismal European growth numbers for the final quarter of 2008. The Bloomberg News consensus forecast calls for the biggest economic contraction in the survey’s 23-year history—underlining the malaise across the continent. Forecasts may nonetheless shift with several Euro Zone member countries reporting their fourth quarter GDP results in the days leading up to the broader EZ figure. Of course, many analysts peg risks for aggregate economic expansion figures to the downside; a near-constant stream of disappointing economic reports give little reason to believe that GDP figures will be better than currently expected. Disappointing numbers will only add further pressure on the ECB to cut interest rates aggressively in order to stimulate economic growth.

It will otherwise be important to watch overall risk trends—especially as they relate to the Euro/US Dollar and Euro/Japanese Yen exchange rates. The short-term correlation between the Euro and the S&P 500 has recently been trading near its highest levels on record, and it remains clear that risk aversion continues to move the European currency. Financial risk appetite generally improved through the past week of trade. Said rallies should have been enough to force bigger gains out of the EUR/JPY and EUR/USD. Yet it remains clear that there are other important factors driving sentiment, and the Euro remains in a broader downtrend. We will have to watch for key shifts in Euro fundamentals—especially as it relates to European growth outlook and Euro Zone stability.

Antonio Sousa is a Currency Analyst for FXCM.