Fundamental Outlook for Euro This Week: Bearish

- ECB members split on how to proceed after rates hit 1.00 percent
- Euro Zone inflation hits a record low – support for holding rates up fading
- EURUSD breaks below 1.31 as the dollar flexes its fundamental muscle

After shaking off the reins of congestion this past Friday, euro traders will jump on the opportunity to develop this momentum into a trend. Whether the currency sustains its new bearing lower or attempts a bullish reversal will be decided by fundamentals. Considering the themes that have driven the world’s second most frequently traders currency in the past weeks as well as what lies ahead on and off the economic docket, we should focus on a number of potential catalysts for significant price action. The most forceful fundamentals are those without a specific release time. The general health of risk appetite across the markets and the growing division between central bankers on where to go after the target rate reaches 1.00 percent will take time and speculation to play out – and therefore they could more surely establish a trend. On the other hand, scheduled event risk will still serve its purpose for a volatility booster and guiding the evolution of economic forecasts.

Any and every currency is influenced by the level of risk appetite behind the market. Whether we are talking about the Australian dollar with its high yield and comparatively strong economy or the Japanese yen and its near-free money and escalating recession, the balance of risk and yield will always be the primary influence on price action. So, where does the euro fit into this scale? Somewhere in the outperform quadrant. Over the past six months, we have seen the euro lose a significant amount of its cache among fundamental traders thanks to a string of rate cuts, obvious recession and growing financial troubles. And yet, the currency is still considered among the strongest in the G10. With a significant yield differential above the US and UK (considering the state of returns across the globe); many bulls are hoping that a near-term, broad economic recovery will find the euro ahead of the pack on interest rates. Whether this is how things shape up or not will likely depend on timing. If a rebound in imminent, the Euro Zone may come out of this period with relatively limited debt, economic damage and loss on returns. Alternatively, if the recession worsens as is expected, the currency’s strength will fade further. Lasting troubles could set off further defaults or help destabilize the union as uneven growth causes tension. Interest rates could be a particular problem going forward. Recently, there has been a notable rift in ECB policy members forecasts for the future. Some (like Weber) suggest the benchmark should not be lowered below 1.00 percent, while others (like Provopoulos) consider it a distinct possibility. This division no doubt exists with abnormal policy efforts like quantitative easing as well; and if the central bank doesn’t apply the appropriate level policy to the problem, their troubles could become significantly worse.

The general health of risk appetite is a vague but omnipresent influence. There is no single sign that conditions are worsening or improving; or whether the euro’s sensitivity to such factors is increasing. However, we can gauge the general shift in such trends through specific scheduled, event risk. Next week, the data on board falls into three general groups. Sentiment gauges like the IFO and ZEW may have lost some of their tout thanks to perceptible rebound in risk appetite throughout the market. Leading growth indicators will have a more immediate impact on price action with readings like the current account balance and PMI figures offering a pace on growth. A reading that could go overlooked (but shouldn’t) is the debt-to-GDP ratio. This is a long-term indicator that is typically considered to have greater meaning in Japan and New Zealand; but it will nonetheless gauge strong the economy will be when things do turn around.

John Kicklighter a Currency Strategist at FXCM.