Fundamental Outlook for Euro This Week: Bearish

- German inflation data suggests risk of deflation for Euro Zone, threat of aggressive ECB action
- Could possibility of a single European financial regulator pose a risk to the Euro?
- Forex options markets point to potential euro/US dollar top
- Technical forecast points to potential euro/US dollar declines

A lackluster week of European economic data and similarly uneventful price action in the S&P 500 left the euro/US dollar exchange rate almost exactly unchanged through the past week’s trade. Early-week EUR/USD losses initially suggested that the pair was likely to continue its recently sharp downside reversal, but markets refused to allow the previously high-flying pair below important lows of 1.3800. The subsequent rally higher fell short at similarly important Fibonacci resistance at the 61.8 percent retracement of the 1.4340-1.3800 move at 1.4130—the “line in the sand” for the nascent downtrend. A lack of major market-moving developments would keep the battle between bulls and bears at its current deadlock, and it is difficult to predict what could actually break the EUR/USD beyond its recent trading range. That being said, we continue to see signs that US dollar sentiment hit a bearish extreme on the Euro’s run to 1.4340—suggesting that we could see the EUR/USD remain below said level through the weeks ahead.

Volatility expectations have generally trended lower ahead of what seems to be a week of limited Euro Zone economic event risk. Yet we remain keenly aware that market tensions can flare up at a moment’s notice, and currency moves remain especially difficult to anticipate. German ZEW survey results could spark minor Euro price moves, but the past two reactions to the historically market-moving report have been anything but intuitive. We will keep an eye out for especially large surprises out of the survey data, but recent experience suggests markets will pay little attention to the results. Recent doubts over the future of European Central Bank monetary policy suggests upcoming Euro Zone Consumer Price Index inflation data will command greater influence on FX markets.

Recent ECB rhetoric suggests that the central bank is relatively unlikely to pursue aggressive monetary stimulus, and the euro has largely benefited from a comparatively stable outlook for monetary conditions. The recent ECB Monthly Bulletin emphasized that the bank feels its actions to date have sufficiently anchored inflation expectations, and the bank expressed relatively sanguine outlook for economic growth. Many have questioned whether the ECB has in fact done enough to stave off risks to deflation—calling for further rate cuts in the face of sharp economic contraction and fast-growing unemployment. Upcoming Euro Zone CPI data could shed some light on price trends, and any especially noteworthy surprises could alter outlook for the future of domestic interest rates. A larger-than-expected pullback in prices would likely force corrections in interest rate expectations and, by extension, the Euro itself.

Otherwise, it will be critical to watch general trends in risk sentiment and its effect the ostensibly risk-sensitive Euro/US dollar pair. The EUR/USD could remain in its uptrend if the S&P 500 and other indices continue higher, but any noteworthy pullbacks in these key barometers could spark similar moves in the US dollar.

David Rodriguez is a Currency Analyst at FXCM.