Fundamental Forecast for Euro: Bearish

- The EU agrees fundamentally agrees to a bailout for Greece but leaves the details for a later date
- Just as financial stability concerns subside, weak 4Q GDP readings add another burden to the euro
- Is EURUSD’s steady, descending trend channel promising new lows or ripe for a reversal?

Just six months ago, the euro was prized for its growth outlook, interest rate forecasts and its status as the primary alternative to the US dollar (a currency that has fallen from grace since the financial crisis). Today, we have a very different picture of the same currency: there is little sign of a rate hike from the ECB on the horizon; Growth is very uneven across the Euro Zone’s various member economies; and the very stability of the European Monetary Union has been thrown into doubt. This is perhaps the most dramatic shift of any of the major currencies; and yet this dire fundamental backdrop is not fully appreciated. In the week ahead, the market will keep its focus on the Greece to see whether EU officials can rescue an economy that is quickly fading without evoking severe side effects along the way.

There are a few approaches the European Union can take to defuse perhaps the greatest threat to its stability in its relatively short history. However, there is no scenario that does not come with a significant potential for failure. The first option (and the most ideal for policy makers) is to maintain a verbal assurance to Greece’s stability and depend upon market sentiment to improve on its own. Realistically, the global economy and financial markets are heading toward recovery; and while the country may not reach its aggressive deficit cutting goals, the progress would be tangible and officials would allow for more time. The trouble with this picture is that risk aversion runs deeper than the health of this single economy or region; and a short-fall will simply concentrate fear around the euro. The more likely outcome is that a single economy or the group could extend a lending facility that will ensure against default and buy the economy time. Here, there is a ‘moral hazard’ issue. Other member economies will see that they will be bailed out should they breech the EU’s guidelines. And, there are more than a few members that could use aid right now and will almost certainly need it should conditions continue to deteriorate.

The more complicated and ominous scenario would be for Greece or another member to eventually secede from the Union. This is a more unlikely scenario; but there are those that believe that this is ultimately inevitable. The Economic and Monetary Union is little more than 10 years old and already major problems have developed. Sharing monetary and fiscal guidelines among many different economies will naturally develop leaders and laggards. Greece, Portugal, Spain and others are in their current state partially due to inappropriately low interest rates through the years preceding the economic crash. Now they are suffering due to 3 percent limits on debt to GDP ratios. It may take a while for such a dramatic change to come to the EMU; but will almost certainly happen eventually.

Regardless of the path officials choose to take with Greece and the fragility of their Union; there is ultimately little they can do to guarantee stability. The only definitive stabilizer would be a general improvement in risk appetite – an unlikely outcome give the abundance of fundamental cracks in the system and excess premium built into the capital markets. If the long-term continuity of the euro is cast in doubt, the currency could suffer a terminal loss of confidence. But, this would be a development that would take time. In the meantime, we will simply match the details of the Greek bailout plan with background risk appetite. And, for short-term volatility, we can look to the number of notable economic indicators that are scheduled for release. The top market movers are the ZEW survey figures and the PMI activity numbers.

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