Fundamental Forecast for Euro: Bearish

- European Union officials agree to joint Euro-are/IMF bailout for Greece should it be necessary
- Moody’s downgrades Portugal’s sovereign debt rating
- Has EURUSD revived its four-month bear trend?

A sharp rebound staged by the euro through the end of this past week may seem confirmation that the market has been comforted by the European Union’s pact to rescue Greece under dire circumstances. However, one day’s advance does not make a trend; and there is plenty of doubt surrounding the agreement that it would not be difficult for this very early recovery to collapse under its own weight. Considering EURUSD accounts for the bulk of total liquidity in the currency market and given this pair’s stable correlation to underlying sentiment trends, the health of the euro still resides in risk appetite itself. Should confidence recover, the euro depressed by disaster scenarios will likely see a recovery as forecasts begin to balance out with those projections for major counterpart currencies. On the other hand, should sentiment collapse, the holes and inconsistencies in the hailed rescue program will shine through and perhaps leave the currency in a worse position than it was in before.

As most know, gauging the ebb and flow of underlying risk trends is highly speculative and requires significant patience. However, it is far easier to predict how the euro will perform under different scenarios. If confidence collapses under its own weight going forward, the focus for this currency will immediately go to the Greek accord that was reached at the end of this past week. At the two-day summit, policy officials agreed (some reluctantly) to a combination of euro-area funded bilateral loans and IMF support should this specific EU member require it. When looking into the specifics of this treaty that it is merely an effort to comfort the markets and buy enough time for the nation’s own austerity measures to take effect. Should conditions deteriorate in Greece any time during its effort to work down its record deficit while simultaneously avoiding an exaggerated recession (and it is highly likely that it will), then Prime Minister Papandreou will likely request aid. Yet, there were no explicit rules for what would qualify a reasonable claim for aid. On the other hand, the agreement stipulates that every member must agree to the need. Furthermore, there was no guidance on the cost of these loans. The group will likely make the lending rate prohibitive to discourage a dependency; but that would make for an even more fragile recovery for the economy. It is estimated that Greece will need to refinance approximately 20 billion euros worth of debt over the next two months; so w may see a call on this contingency plan rather soon.

Further concern that the EU’s rescue plan could fall through comes from an underestimation of the how broad the problem actually is. This backup plan was drawn up explicitly for Greece; but there are many other members that are struggling (most notably Ireland, Spain, Portugal and Italy). The ECB’s Bini Smaghi commented that he saw no moral hazard in this plan; but should any other members be backed into a corner, they will reasonably expect help as well. Another haphazard solution won’t cut it a second time around; and a workable euro program like the recommended EMF is a long ways off. This is yet another reason that the EU is heavily dependent on smooth market conditions going forward.

On the other hand, should risk trends hold steady or improve; euro traders will once again turn back to growth and interest rate speculation. On this front, independent forecast for European expansion are lagging its peers while the timing and 12-month forecast for rates trails that of the US. Data will help refine these set forecasts. Heavy macro data with high short-term volatility potential includes German employment, German CPI and the Euro Zone CPI estimate.

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