Fundamental Forecast for Euro: Bearish

- Euro hits five-month low on S&P 500 tumbles
- Fear of Greek debt crisis spreads to Spain and Portugal, sends Euro lower
- Forex futures and options forecast for Euro shows many fear further losses

The Euro finished the week substantially lower against the safe haven US Dollar on sharp declines in the US S&P 500 and broad deterioration in financial market risk appetite. The ongoing budget deficit crisis in Euro Zone member Greece grew beyond its borders, causing a substantial widening in sovereign bond yield spreads for countries such as Portugal and Spain. Arguably the worst crisis to threaten the stability of the European Monetary Union to date, market reactions only exacerbated losses and the Euro was especially weak against the resurgent US Dollar.

Short-term forecasts subsequently depend on the trajectory of financial market risk sentiment, how it relates to European asset classes and the continued viability of the EMU. Though the 16-member Euro zone is no stranger to turmoil, sustained budget crises threaten to shake the foundations of the union and present real danger to the euro. Markets are subsequently likely to ignore anything but the biggest surprises in upcoming economic event risk and instead pay very close attention to ongoing activity in sovereign deficit troubles. The key question rolling forward is whether or not Greece can contain its growing budget deficit and whether any problems in one country can cause contagion across the broader Euro Zone. Similar budget issues in Portugal and Spain have come to the spotlight despite their comparatively manageable fiscal shortfalls and underline risks that fiscal troubles may spread to other EMU members.

Greece is in special danger not only due to the sheer size of the fiscal deficit as a percentage of GDP, but any political efforts to institute cuts in spending and rein in the deficit have been met with fierce popular opposition. The political deadlock is especially troubling given that the Greek government will need significant funding in the months ahead as the deficit grows and interest rate payments skyrocket. If markets are unwilling to purchase Greek debt, then it seems likely that the strongest EMU countries may need to bail-out the debt-ridden country. Hawkish rhetoric from European officials suggests that few can stomach any such action, and it will be critical to see any and all developments in what remains a volatile situation across the common currency zone.

Fundamental data in the week ahead will likely take a backseat to broader financial market activity, but it may be important to watch any surprises in upcoming Q4, 2009 Gross Domestic Product reports from individual countries and the broader Euro zone economy. Consensus forecasts call for the second consecutive quarter of Euro zone economic growth at a 0.3 percent QoQ change. Any especially sizeable surprises could have pronounced effects on domestic financial markets and—by extension—on the highly risks-sensitive Euro currency. Long-term correlations between the Euro/US Dollar exchange rate and the US S&P 500 remain near record-highs and emphasize the pair’s sensitivity to risk appetite. Suffice it to say, any strongly negative GDP data releases or continued EMU deficit struggles could have similarly dire effects on the Euro.

DailyFX provides forex news on the economic reports and political events that influence the forex market.