Fundamental Outlook for Euro This Week: Bearish

- ECB President Trichet puts a gag order on policy members to quell speculation
- German unemployment rises for a sixth month while Euro Zone jobless rate hits 8.9 percent
- Do technical forecasts conflict with the Fundamentals? Read the FX Technical Weekly to find out

It is fitting that the euro is on the cusp of a dramatic trend change considering what is at stake from the fundamental side of the currency this week. While the world’s second most prolific currency has been visibly restrained from developing a major trend against most of its major counterparts recently; it is the EURUSD pair that is the most meaningful. The most liquid currency cross in an already unfathomably deep market, this pair is reflective of the most elemental trends underlying the global economics. As such, the ominous and repetitive test of a dominant trend, that has defined price action since July of last year, is a sign that that a market-defining trend may be underway. From the global perspective, such a shift is likely indicative of a change in investor confidence. However, for the euro’s part, the development of a new trend will come from the forecast for monetary policy and the repercussions it carries.

If we are looking for a catalyst that could renew the euro’s decline or mark its definitive reversal, the ECB’s rate decision on Thursday is one of the few indicators that can do just that. Since October, the central bank has shaved 300 basis points off its benchmark lending rate to a record low 1.25 percent. Despite this aggressive pace of easing, the currency has been able to retain its status as a relative high yield. Until now. While there is a clear interest advantage under current rates, the market’s real concern is where the benchmark will stall and how quickly it can recover so that traders can jump in the currency ahead the crowd to take advantage of the appreciation in the currency as investment capital that naturally follows higher rates of return. The ECB’s vow to target inflation, wait-and-see approach and now reluctance to use un-conventional measures to recharge the economy has led the market to believe that the European policy officials would keep the target lending rate up long enough for the global recovery to take over and then proceed on a rate hike binge to prevent another inflation boom. However, with each cut and the steady decent into recession; we have seen the conviction fade. Now, just days away from what economists expect will be another 25 basis point cut, the central bank President Trichet had to put an unofficial gag order on the governing members to prevent wild speculation generated by the dissension of various voters. The cut itself would not be the catalyst for a move. The real shock would come from the use of unusual policy methods (quantitative easing) and to a lesser extent keeping the door open to further easing. This would be taken as a sign that the European market and economy is essentially in the same boat as its British and US counterpart.

Along other lines, general risk sentiment will be a sweeping market driver; but the euro’s correlation to such trends are inevitably linked to the outcome of the rate decision. A steady policy approach would be considered a sign that officials are confident of a recovery and the euro will be considered a high reward, relatively low risk currency. On the other hand, a dramatic shift in its approach will put the euro on the same level as the pound or Canadian dollar (who are neither a safe haven or yield generator). However, along the way, we also have a significant round of top tier economic indicators that will offer better bearings on growth forecasts. Among the notables are Euro Zone retail sales, investor confidence, industrial production, German factory orders and trade numbers. While these will have a lesser impact on volatility and trend seeding, they will certainly influence the bearing of economic forecasts and the euro.

David Rodriguez is a Currency Analyst at FXCM.