Fundamental Outlook for Euro This Week: Neutral

- Euro Zone factory and service sectors contract at the slowest pace in 8 months
- German investors lament current conditions but growing more optimistic over the future
- Is the EURUSD breakout just beginning or is this the last gasp? Read the weekly technical outlook

The euro was set on a steady and aggressive rally against its primary counterpart - the dollar – this past week. The drive for this rally evolved with time: from scheduled event risk to general market sentiment to speculation over national credit health. However, when the dollar is subtracted from the equation, is the euro really as strong as the EURUSD advance would suggest? Looking over the crosses, the single currency was eking gains against those economies that are struggling to maintain stability and depreciating when measured up to the high yielders. This should be considered a reminder that there are general market themes and euro-centric fundamentals; and the market will follow whichever has the greater influence at the time. Looking ahead to next week, there are a number of factors that could come into play including monetary policy speculation, growth forecasts and the permanence of sovereign credit ratings. Which will take responsibility for the guiding the euro?

Considering the market’s reaction to Standard & Poor’s downgraded forecast for the UK’s credit rating this past week, this has the greatest potential for market impact going forward. The pound immediately dropped when the news crossed the wires; but the real reaction came from the dollar as rating concerns spread to the United States as budget deficits and bank rescues swell debt levels. For the world’s largest economy, even a passive threat of a credit downgrade is substantial (as its assets are the benchmark for risk-free); but what is the danger to the Euro Zone? Speculation is a tricky thing to gauge; but under the right conditions, a threat to the European regional credit rating could certainly undermine the currency. With the US losing its safe haven status, UK considered financially unsound and Japan suffering from a record-breaking recession; the Euro Zone is considered one of the most secure, developed economies. Invalidating this perception could quickly undermine confidence in the economy and its assets. However, we have to consider how real a threat this is. According to Eurostat numbers, the government debt to GDP ratio through the end of the year was at 69.3 percent. What’s more, we have already seen Greece, Spain, Ireland and Portugal downgraded individually. With the global policy makers trying to stabilize a global recession and stamp out the lingering effects of a financial crisis; all major economies are at risk.

Another potentially, potent fundamental driver for the euro going forward is monetary policy. While its benchmark lending rate is well below the Australian and New Zealand targets, the Euro Zone rate advantage was considered relatively stable – until recently. At the authority’s last policy meeting, officials cut rates once again to 1.00 percent and relented in taking the first step into un-conventional territory by announcing their intentions to purchase covered bonds. Forecasts among policy officials vary widely as to whether the central bank has done enough or if they are lagging the potential for crisis. Divergent commentary will continue to split the market and bolster volatility; and the louder the call is for additional cuts and expanding quantitative easing, the heavier the euro will become.

The third potential driver for the euro next week is scheduled event risk. A prominent list of economic indicators, the docket may not only trigger short-term volatility; but it will also feed into the aforementioned themes. The offerings are substantial. Sentiment is covered by the IFO business and GfK consumer numbers. Growth forecasts will follow German employment and retail PMI figures. And, though its influence is likely dampened German and Euro Zone consumer-inflation data could still contribute to rate forecasts.

John Kicklighter a Currency Strategist at FXCM.