Fundamental Forecast for Euro: Bearish

- Rating agencies Moody’s and Standard & Poor’s warn a Greek downgrade may be on the way
- German business confidence contracts for the first time in 11 months through February
- EURUSD maintains its steady bear trend despite recent congestion

There is a lot going on in the Euro Zone; and yet the euro seems to have little control over its own bearing and volatility. In effect, the currency is being influenced by its own fundamentals; it just so happens that anxiety and uncertainty are keeping the euro itself anchored. This opens the currency up to cross market flows. However, this passive contribution to price action won’t last forever. There is a ticking time bomb in the form of a Mediterranean country that will either explode or be defused. The fear surrounding Greece has recently tempered along with the broader sense of risk appetite across the market. However, the government is merely buying time with its calm assurances and pledges to act without a clear contingency plan. The situation in Greece will likely reach a head; but its true impact on the euro will depend on what effect its troubles have on the collective. And, while we wait on this fundamental menace to develop; there is plenty of event risk to fortify or undermine the currency’s position over the coming week.

In any form of analysis, it is better to establish a ‘big picture’ perspective and work your way down to the nitty gritty. For euro traders, the overbearing and primary concern is the stability of the European union itself. In adopting the common currency, the member economies have also taken on a shared monetary policy and fiscal governance. These rules are clearly easier for some economies to follow than others; and this inequity is showing through. Traditionally, Greece has responded to sharp economic downturns by increasing its deficits (by increasing government spending) and/or devaluing its currency. Under the control of the EMU, the country no longer has these options available to it. The regional government has been tasked with severe spending cuts that would return the deficit to a level that is within bounds. However, this will naturally curb an economic recovery and extend the slump Greece suffers. National strikes suggest citizens may not tolerate these austerity measures and there is no guarantee that such aggressive targets can even be met within the given time frame.

This situation can develop and deteriorate until something finally gives – which could take quite a while. Yet, there are a few events that could speed this process up. The most obvious threat to destabilizing this economy is a renewed sense of market-wide fear. More specific though is the recent threat of downgrades by rating agencies Standard & Poor’s and Moody’s. If the nation’s sovereign credit rating is lowered, it will be much more expensive for the government to raise the necessary to roll its debt much less finance future spending. At this point, the probability of a bridge loan is very high. However, such a move would hardly solve the problems of Greece; and it would further invite moral hazard and damage confidence for the rest of the Union.

Another side effect of the financial instability in the euro-area is the impact it has on monetary policy. The ECB is scheduled to meet this week; yet the probability of a rate hike is nonexistent. In fact, the odds of a hike anytime this year are very low. With many member economies struggling to pull themselves out of recession and exacerbating financial strains along the way, there is little reason for policy makers to act on absent inflation. This past week, the core inflation gauge for the Euro Zone would hit a 0.9 percent annual pace to match its lowest reading on record. Look for commentary from the central bank, not action. Other indicators that could be good for short-term price action include the Euro Zone 4Q GDP revision, the leading CPI forecast and the regional unemployment rate.

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