Fundamental Forecast for Euro: Neutral

- Long-term fundamentals are still a disappointment for the euro heading into the end of the year
- German consumer-based inflation figures hit an eight-month high – the hawkish crowd garners momentum
- Short-term EURUSD technicals clash with longer-term trends

We are at the end of the year, and our assessment of the performance of the euro depends on the time frame at which we approach the currency on. If we were to gauge its strength over the past year, it would undoubtedly be an appraisal of unabashed strength. On the other hand, if we measured the euro’s health in just the past month, we would have to deem the currency exceedingly week. However, as traders, our interest is asking where will markets go – not ruminating too much on where they have been. And, considering we are at the end of the week and 2009; the fundamental activity going forward can be significant. Through the immediate future, we will see market liquidity fill back out and volatility subsequently recovery. Considering this pick up in market conditions will accompany a meaningful round of economic event risk, the potential for volatility and trend development is notable. Yet, when it comes to developing dominate trends; we will have to monitor the major fundamental drivers such as the strength of the dollar, the direction of underlying risk trends, and the ubiquitous matter of where the euro stands in the global spectrum of monetary policy.

Starting with the larger trends first, the return of liquidity could play a big role in how the euro trend is shaped into the opening week of the year. With the market filled out, the masses will be less concerned with profit-taking and participants will be able to return to the prevailing trends that have defined direction through most of 2009. The dollar’s health will no doubt take a major toll on the euro’s health heading into the New Year just as surely as it defined price action through the past year. From the perspective of nations, central banks, large banks and individual traders; the euro is considered the primary counterpart to the US dollar. This is an important distinction when you consider the IMF released a report this past week that showed the euro’s presence of global reserves rose to a record and the dollar’s prevalence hit a 10-year low. When policy officials look to diversify away from the dollar, they will first turn to the euro as the world’s second most liquid currency. In turn, this will mean wholesale buying or selling of the greenback and the opposite for the euro .

Another prominent driver for price action is the direction and intensity of risk appetite. Investor sentiment, will have an indirect impact on price action through demand for the US dollar (one of the top funding currencies for the FX market); but it will also impact the euro as a region that still looking at financial troubles but is also looking to lead the global economic recovery. Sentiment has stalled through the final months of the year (we can look at the Dow Jones Industrial Average as a benchmark); but we haven’t seen a clear tip towards risk appetite or aversion when things heat back up.

Finally, there is interest rate policy to consider. Though there has been little development in the global rebound in interest rates, speculators are chomping at the bit when it comes to forecasting which currencies will enjoy accelerated rate hikes (which will drive capital gains on early adopters before the yield can really offer a profitable differential). Through the end of this past year, there has been little to no precedence offered by the ECB of near-term rate hikes; but there has been a tangible rollback in stimulus programs over the past few months. In the meantime, no other central bank (with the exception of the RBA and arguably the RBNZ) has moved up their own time frame. This means the field is still wide open for rate speculators

Look at next week’s economic docket, we could find some headway on ECB rate speculation. Perhaps the most influential indicators in the mix is the Euro Zone CPI estimate for December. The advanced inflation indicator is expected to accelerate into positive territory; and therein lies the most tangible force for hawkish officials. Other indicators can have a significant impact on growth and inflation; but their influence over actual policy will likely be reduced. Nonetheless, watch the German employment data, Euro Zone sentiment indicators and regional sales figures for volatility.

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