Fundamental Outlook for Euro This Week: Bearish

- European CPI data could shed light on future Euro interest rates
- Evidence mounts that the ECB will cut interest rates further
- Traders punish the Euro following ECB Monthly Bulletin
- Forex sentiment points to bearish Euro forecast against US Dollar

The euro was the worst-performing major currency against the US Dollar on the week, as a slew of evidence suggested the European Central Bank could match the US Federal Reserve in extraordinarily low official interest rates. Indeed, the single currency generally fell out of favor following the release of the ECB’s Monthly Bulletin. The report showed clear risks of Euro Zone deflation and implied that the ECB could cut rates further through the foreseeable future. The single currency maintains a slim yield advantage over its US counterpart, as the US Federal Reserve’s aggressive monetary policy has taken US Dollar interest rates near zero percent. Whether or not the Euro may recover against the resurgent USD may subsequently depend on several interest rate-linked economic reports in the week ahead.

European macroeconomic trends point to further sharp contractions in regional economies, but bearish consensus forecasts for upcoming economic reports suggest that markets have largely discounted Euro Zone fundamental weakness. Indeed, there have been very few data releases that have forced major moves in the Euro or elicited strong shifts in trader sentiment. Recent sensitivity to European Central Bank interest rate expectations nonetheless implies that upcoming Consumer Price Index results could spark major EUR/USD volatility. Consensus forecasts call for a 0.6 percent year-over-year CPI inflation rate—a full 1.4 percentage points below ECB targets of 2.0 percent. Traders will certainly scrutinize the inflation release, and any significantly above or below-consensus print would almost definitely force sympathetic moves in the Euro and domestic assets.

Euro traders will otherwise monitor overall risk trends—especially as they relate to European markets and the single currency itself. The Euro/US Dollar exchange rate had previously moved almost tick-for-tick with the US S&P 500 and other risk barometers. A recent recovery in financial market conditions has meant that the Euro is far less correlated to risk sentiment. Yet the severity of the S&P 500 comeback suggests that such moves are unsustainable. The heavily-traded US equity market index has now rallied over 25 percent off of its March lows—an incredible annualized pace of over 1000%. When the correction comes, the Euro could almost certainly suffer alongside major risky asset classes. It will be important to watch overall market trends—especially as they relate to the EUR/USD exchange rate.

David Rodriguez is a Currency Analyst at FXCM.