Fundamental Forecast for Euro: Neutral

- The ECB maintains its benchmark lending rate, Trichet sees little threat of inflation
- The fallout from Greece’s financial woes could spread well beyond its national boarders
- EURUSD maintains its stable, ascending channel; but when will volatility return?

While the EURUSD exchange rate can be somewhat misleading as a gauge of strength for the euro (as it has recently been more responsive to the US dollar), the benchmark pair is currently offering an accurate portrayal of the single currency. A breakdown of the position the world’s most liquid currency pair is in reveals a steady three-week trend channel (imbued with a bullish bias due to the dollar’s general weakness) whose most recent trend was in full position of the bears. Taking a quick glance across the majors, it becomes apparent that nearly every one of the euro crosses is sitting at the bottom of a broad range. It is make-or-break time for the unloved currency; and the catalyst for its ultimate bearing will likely fall to one of three pressing issues: the financial stability of the European Community (with a big highlight on Greece); a solid run from the US dollar; or a meaningful change in interest rate forecasts.

Taking the euro’s most prominent concerns in order of their respective threat level; we have to first defer to the US dollar. As the world’s most liquid currency, the greenback has incredible pull in the currency market. It is only natural that its most actively traded pairing (EURUSD) should feel the effects of a meaningful drive from the ubiquitous security. In the past three weeks, this link hasn’t proven a burden as the dollar has essentially passed the time without a clear direction; but then again, this stability could very well act as an anchor on the euro. Looking ahead, stability will be difficult to maintain. This is especially true considering EURUSD has adopted the role of the market’s stable carry trade. While there is actually a very small yield differential attached to this pair, the dollar’s role one of the favored funding currencies naturally transmits its risk convictions to its most liquid pairing. Should risk appetite rally or plummet, expect EURUSD to follow suit.

The next major concern is perhaps not universal as underlying investor sentiment; but it has proven a distinct driver for the euro itself over the past few weeks. Fundamental troubles are not unusual for the regional economy; but it seems that the failing financial health of Greece has taken a particular toll on the outlook of the European community and their currency. What makes the ballooning deficit of this Mediterranean nation more threatening than Ireland’s banking crisis, potential Eastern European defaults or lasting recessions in key members’ economies? Realistically, all of these concerns are playing into the attention on Greece. And yet, the situation with this country poses a threat to the stability of the European Union. The downside of developing a single market among different nations has been bared through the recent economic difficulties. While German and France have been quick to recovery as the group’s largest members, others have struggled to recover. Furthermore, with membership, each government gives up its right to adjust monetary policy, manipulate its currency, increase its debt load and many other points of flexibility that have in the pace helped economies to adapt to unfavorable conditions. It will be a tall order to meet the goals policy makers have set out and officials have warned no exceptions will be made.

After the ECB’s decision this past week to hold its benchmark lending rate unchanged and President Trichet’s suggestion that there was no threat of medium-term inflation, interest rate considerations have been pushed into the background. However, as the global economy recovers, this source of yield will be an essential element of value. Currently, the market is pricing in 89 basis points worth of hikes through the next 12 months, which puts the euro ahead of its US, UK, Swiss and Canadian counterparts. However, British officials have already warned that short-term inflation pressures were a concern and US inflation has pushed above the central bank’s target. Perhaps a shift in growth will bolster these forecasts. The PMI figures due on Thursday are often considered leading indicators of growth.

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