Fundamental Forecast for Euro: Neutral

- EU receives the results of its own financial stress test and the prognosis is promising
- Euro Zone Unemployment is now at a 10-year high of 9.6%
- German and regional inflation gauges still pitched into negative territory

There are more than a few concerns for fundamental euro traders in the days ahead. Where just a few months ago, the single currency was considered among the best speculatively positioned economies given its optimistic outlook for growth and hawkish bearings; we now see the euro struggling to find its place in a broad spectrum of relative risk and safety. In the normal scale of yield and risk, the euro stands just in the middle of the spectrum which leaves it to be jostled by speculative winds that find greater response from high yield (Aussie dollar) and struggling funding currencies (the US dollar). However, speculation is ever active; and some long-term considerations are starting to come to term. Among the most pressing concerns is the pace Euro Zone’s recover (especially in comparisons to that of the US) and the lingering potential for financial instability.

Just this past week, the EU completed a five-month long stress test of its financial markets; and according to policy officials, the results are promising. ECB President Jean-Claude Trichet required the evaluation of the banking system be put up against an “adverse” scenario. In the end, none of those institutions surveyed were expected to see their tier one capital ratios fall below 6 percent (the Basel minimum is 4 percent) even in the worst of conditions. However, skepticism is likely to develop just as surely as it did after the US test. It is reasonable to question why there were only 22 banks for such a broad region and what the methodology they measure risk; but the real concern Is in the 400 billion euros of additional losses the market could sustain under the most extreme conditions. We have already seen 489 billion n losses so far; but other outfits have suggested the region could see far more ahead with the IMF suggesting European banks have disclosed only 40 percent of their losses.

In the near-term, the outlook for growth and interest rates will take center stage. The World Economic Outlook has upgraded its outlook for expansion for the union with 0.3 percent expansion expected in 2010 and a more restrained (than previously expected) 4.2 percent contraction for the currency year. That a sluggish pace when compared to the 1.3 percent growth expected from the US or 2.7 percent positive turn for Japan. These are forecasts that are certainly weighing on the euro now; but data can quickly eat into this discounted scenario. It is worth mentioning that the timely, September PMI composite indicator has reported expansion for two months (after deteriorating since June of 2008). Maintaining the pace of production after inventories build up and facilitating consumer spending will be the keys to sustainable growth. Yet, officials are also looking for a crutch for recovery in a unified “strong dollar” position that could bolster export revenue. In a recent address, Trichet stated blatantly that a healthy greenback was “extremely important.” This can be interpreted indirectly that he is very concerned about the high level of his own currency.

Where growth goes, interest rates will follow; but at this pace, it seems like the hawkish turn from the ECB will be far down the line. Yet, with the market being told that the benchmark will be held well into next year, we have the makings for speculation to gauge the likelihood that we will in fact see a move sooner. Overnight index swaps measured by Credit Suisse price in no chance of a rate hike on Thursday – not a surprise. At the same time, there is a total of 82.8 basis points of firming priced in over the coming year. With the central bank already announcing it was culling its unlimited fund auctions, we already have the first steps towards hikes. This is a policy body that won’t be able to telegraph its intentions to hike with a preceding trimming of abnormal monetary stimulus (like the UK cutting its bond fund); but they will try to be as transparent as possible. And, that is why we will have to absorb everything said after this week’s rate decision.

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