Fundamental Forecast for Euro: Neutral

- German investor confidence suffers its steepest monthly drop since October 2008
- A successful debt auction quiets fear that Spain needs an EU/IMF rescue similar to Greece
- Is EURUSD bullish run a lasting reversal or temporary correction?

There was a clear skew in the euro’s performance across the majors this past week. There was no clear division on the shared currencies performance regardless of whether it was paired up with a high yield, safe haven, fundamentally robust or financial unstable counterpart. As evidence to this unusual mix, the euro advanced 2.2 percent against the US dollar and 1.2 percent versus the Canadian dollar. Alternatively, the Aussie dollar climbed 0.3 percent and the franc 1.4 percent. This tells us that there is no definitive driver for the broader market (risk appetite, sovereign credit risk, growth expectations); and the euro itself cannot simply advance on the virtue of a overdue rebound (like it has done with EURUSD). Looking to the week ahead, we have to balance the speculative mass’s confidence in the Euro Zone’s financial stability; the level of risk appetite that prevails; and the fundamental standing of the economy itself.

First things first, the concern that initially drove EURUSD to its four year low was the uncertainty surrounding the financial stability of the European Union and the durability of the euro itself. Many things have happened over the span of two months including a near Greece default and the adoption of an unprecedented 750 billion euro rescue package. Over the past two weeks, a positive turn for the euro would suggest conditions have actually improved; but is not necessarily the case. In fact, conditions have arguably deteriorated. Rumors have circulated that Spain is on the verge of asking for its own assistance aside from the European Financial Stability Facility. A figure of 250 billion – if realized – would not only stoke fear that the region is not stable; but it will significantly leverage the expected cost for stabilizing the region. Should Spain (or any other EU member for that matter) access the EFSF or request a unique package, it would almost certainly destroy the flimsy confidence that is currently in place. Another immediate threat to Europe’s financial picture are the results of the stress tests performed on individual banks. This follows the lead that the US forged when it reported the health of the 19 institutions that tapped the TARP fund. The difference between the EU and US efforts: the latter injected funds into those firms that were deemed to be undercapitalized. ECB board member Paramo said the central bank would “absolutely not” provide private banks with capital. Will individual government’s put in a safety net? Unlikely considering they are suffering their own financial troubles.

Another critical factor to the euro’s performance going forward is the bearing on investor sentiment. Robust risk appetite is critical to riding out events and indicators that could be construed as threatening, while further fueling demand for an economy that is expected to suffer an extended period of economic stagnation on the basis that it is oversold. The erratic nature of speculative sentiment is difficult to project. There are no particular indicators that could be expected to meaningfully alter the course of market-wide risk appetite. It all comes down to the fine balance between fear and greed. For the euro’s own part however, the CFTC’s Commitment of Traders report for the week ending June 15th revealed the net speculative short interest in euro futures dropped an astounding 44 percent through the period. This certainly eases the bullish pressure from short covering. Now traders actually have to buy into the currency on the assumption of strength.

As for the standard economic fodder, euro traders will have a lot to take in to develop their growth and interest rate expectations. The outlook for rate hikes is anemic (the market is pricing in 32bps worth of hikes over 12 months) and the money supply report will most likely support a neutral policy stance for the foreseeable future. As for growth, the service and manufacturing PMI numbers for June will round out the second quarter growth forecast. Also interesting for economic activity are the EZ and German consumer confidence and German IFO business sentiment indicators.

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