Fundamental Forecast for Euro: Bearish

- German IFO Rises for Third Consecutive Month in June
- ECB’s Trichet Says Current Interest Rates ‘Appropriate’
- OECD Says ECB Should Cut Interest Rates Near Zero

Euro volatility looks likely in the week ahead as the European Central Bank issues a highly contested interest rate decision. The central bank is facing mounting pressure to provide greater monetary stimulus, with the Paris-based Organization for Economic Cooperation and Development (OECD) urging the central bank to cut borrowing costs toward zero and keep them there into 2010 while Credit Suisse’s overnight index swap index reveals traders are now pricing in a 56.5% chance of a 25 basis rate cut, a sharp reversal considering they were reflecting a 62.7% chance of a rate hike just two days ago. Looking past the admittedly global phenomenon of dismal economic growth in 2009, arguably the most pressing reason to reduce the cost of money is to check the onset of deflation. An early CPI estimate is expected to show that prices shrank at an annual pace of -0.2% in June, the first negative reading on record since the creation of the single currency in 1991. The latest PPI report supports continued pressure on consumer prices, with forecasts calling for wholesale inflation to shed -5.6% in the year to May. Entrenching expectations of lower prices threatens to commit the currency bloc to a long-term period of stagnation as consumers and businesses are encouraged to wait for the best possible bargain and perpetually delay spending and investment.

For their part, a rotating cast of ECB officials including President Jean-Claude Trichet have said last week that current rates are “appropriate” for the time being, with perennial hawk Axel Weber saying the bank has “used the room for rate reductions that was created by waning inflation risks,” adding that “additional steps are not necessary.” Although the ECB did offer an unprecedented 442 billion euro in 12-month bank loans as a means of de-facto monetary easing and will also move forward with a 60 billion bond-buying scheme announced at the last policy meeting, these measures may prove woefully inadequate, as there is no guarantee that banks will lend out the funds raised from action and thereby stimulate the broad economy. Indeed, banks may chose to hang on to the cash as a buffer against $1.1 trillion in as yet unrealized losses linked to the subprime mess, per the IMF, as well as the fallout from a developing currency devaluation in Latvia. Still, the ECB appears unfazed and seems resolved to trade away economic performance to assure inflation is kept in check, with ECB member Jurgen Stark openly suggesting that GDP growth may say low “for years to come”. This opens the door for traders to punish the Euro as they price in expectations that the region will substantially lag behind other industrial economies in recovering from the current downturn, forcing interest rates to stay lower for longer than elsewhere.

Elsewhere on the calendar, Euro Zone Economic Confidence figures are expected to tick up in June, though as we have noted previously, some recovery in sentiment is to be expected as governments’ fiscal efforts filter into the broad economy; the big question at this stage is whether growth is sustainable after stimulus cash dries up. German Retail Sales and Unemployment figures are also on tap: annualized receipts are set to drop for the fourth consecutive time in May, this time by -1.6%, while the jobless rate returns to a 16-month high at 8.3% in June after slipping to 8.2% in the previous month. The analogous reports for the greater Euro area are not expected to be any more encouraging: EZ retail sales are set to drop -2.6% in the year to May while the unemployment rate reaches a near-decade high at 9.3%.

Finally, traders would be wise to continue monitoring trends in risk appetite, with EURJPY and EURUSD still 83% and 88% correlated with the MSCI World Stock Index, respectively.

Terri Belkas is a Currency Strategist at FXCM.