Fundamental Forecast for Euro: Bearish

- Tension building as Greece is on the verge of default while Spain’s credit outlook is downgraded
- ECB maintains its outlook for a moderate recovery in 2010
- EURUSD’s technical backdrop ready to support bearish momentum

The euro’s biggest fundamental driver is the health of the US dollar. This past week, the greenback forged ahead and the euro suffered for it across the board. As the primary alternative to the US currency, there has been a frenzied demand for the euro as the need for return and stability sent capital into the large market. However, when the tides turn and the expectations for return in the United States improves and the irrational fear that the benchmark currency will not just loose prominence but completely fall off; speculative capital will reverse course. At the same time, there are also factors for a fundamental weakening of the Euro Zone itself. The economic and interest rate outlook are cooling, especially when compared to the region’s industrialized counterparts. And then there is also the instability that member default and/or possible withdrawal from the union may bring.

Over the past few weeks, fear has gained traction among the speculative crowd. With the markets bound to general congestion for the better part of two months, traders are naturally going to grow weary of potential reversal threats. Initially, panic was sparked by Dubai World’s default/debt restructuring. Now, the focus is turned to mainland Europe. In quick succession, we have saw Greece’s sovereign credit rating downgraded and the outlook for Spain reduced to ‘negative.’ This speaks to the economic troubles that exist outside of Germany and France and the lack of flexibility that policy makers have in stabilizing individual economies and markets. Finance Ministers cannot take on more debt than the Union allows, devalue their currency or adjust interest rates to help their economies along. This leaves restrictive parameters on nations that perhaps cannot recover naturally and must either seek bailouts (which will take many years to work off) or consider withdrawal from the regional collective. Either outcome could severely undermine the stability of the euro.

Another gradual shift against the euro is its perceived fundamental strength. Six to nine months ago, speculators expected the Euro Zone would be the first of the major economies to recovery from the global recession and its policy authority would usher in the revival of yields. However, as the months passed; it became more and more clear that the European economy was seen falling further and further back in the pack for growth and the ECB maintained a solid front against raising interest rates until a recovery was certain. Today, growth for the region is expected to trail that of the US and Japan; and there isn’t even a clear outlook for a return to hawkish policy by the middle of the year (which is the time frame the Fed is working with). So, gradually, the fundamental advantages are slipping away from the euro; and fresh data is now gauged for its ability further throw the breaks or perhaps increase competitiveness. On this front, we have plenty of key indicators to work with over the coming week. For growth, the December PMI indicators for Germany and the Euro Zone will offer key benchmarks for 4Q activity. For the ECB, regional inflation indicators will tell officials whether they should start responding with measured rate hikes to compliment other efforts to rein in policy. Altogether, expect these indicators to offer short-term volatility and fine-tune adjustment to larger fundamental bearings; but meaningful trends will fall to the dollar and potential crisis.

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