Fundamental Forecast for Euro: Bearish

- Euro hits fresh 2010 lows, contemplates next move
- EUR/USD advance likely limited following 750 billion euro EMU bailout
- Extremely one-sided Euro positioning nonetheless makes short positions less attractive

The euro finished the week sharply lower against the US dollar, trading to its lowest levels since November, 2008 on continued fiscal crises across the single-currency bloc. An announcement that the European Monetary Union would establish a central fund to distribute direct funds to fiscally troubled members initially sent the Euro sharply higher against major counterparts. Yet markets were just as quick to sell the Euro once the initial buzz died down and traders truly assessed the substance of said package.

The greatest shock of all may have come on the announcement that the fiercely independent European Central Bank would directly purchase Greek and Portuguese debt—arguably tarnishing their reputation as an apolitical inflation-fighting central bank. Yields on Greek debt unsurprisingly tumbled as the ECB actively purchased securities, but it is worthwhile to note that sharp deterioration in financial market risk sentiment left the Greek 10-year bond’s yield at a whopping 7.71 percent through Friday’s close. One has to wonder whether such grandiose efforts will legitimately limit the fallout from continued EMU fiscal crisis. Aggressive Euro selling certainly suggests that markets remain skeptical of bailout schemes, and momentum plainly favors further EURUSD declines.

An ostensibly busy week of economic event risk threatens further Euro volatility, but primary market focus will likely remain on the worst EMU crisis in its relatively brief history. Officials have tried time and again to stem speculation that at-risk countries such as Greece and Portugal could default on their debt obligations. Yet skeptical traders continue to demand substantial premiums on Greek bonds—despite explicit guarantees on its debt. How this all plays out will likely decide the medium-to-long-term trajectory of the Euro itself, and continued market turmoil bodes poorly for more short-term direction.

From a trader’s perspective, it is admittedly difficult to sell the Euro against the US Dollar given its substantial losses to date. Recent CFTC Commitment of Futures data showed futures positioning at a record net-short the Euro against the US currency. Such incredibly one-sided bets limit how much further the currency pair may continue to decline, and any signs of potential reversal could just as easily force a substantial rally as traders scramble to cover their leveraged EUR short positions. Recent market volatility emphasizes that traders should remain very cautious as markets grow especially unpredictable.

We maintain a cautiously bearish short-term bias on the Euro/US Dollar, but we advise against using excess leverage amidst substantial forex market volatility. Our DailyFX Volatility Indices continue near their highest levels since early 2009, and we are likely to see further extreme moves into the weeks ahead. Any surprises from the EMU and ongoing fiscal crises could force especially large moves across EUR pairs.

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