Fundamental Forecast for Euro: Bearish

- German Labor Market Continues To Improve
- Unemployment Holds At 12-Year High
- Portugal Auctions 2014 and 2023 Bonds, 3 Month Euribor Climbs to A Fresh Yearly High of 0.896%

The Euro maintained the rally from June, with the exchange rate rising above 1.3100 for the first time since May, but the near-term advance could taper off over the following week as the European Central Bank is likely to maintain a dovish bias for future policy.

At the same time, the results of the EU commercial bank stress test appears to have calmed fears surrounding the European banking system as the outcome showed only 7 of the 91 institutions failed to meet the Tier One capital ratio of at least 6%, and the increase in transparency may keep the single-currency afloat going into August as investor confidence improves. Meanwhile, the Basel Committee on Banking Supervision announced plans to set a leverage ratio that will apply to banks worldwide starting in 2018, but will allow “some prudent recognition” on deferred tax assets as well as minority interest held at other financial institutions as capital.

However, the ECB held a cautious outlook for the economy and expects banks to tightening borrowing standards further over the coming month as the financial system remains fragile, and the central bank went onto say that “negative spillover effects from the sovereign debt crisis appears to have worsened banks’ ability to obtain funding,” which is likely to weigh on the recovery going forward. Nevertheless, the economic docket showed the CPI estimate increased to an annualized pace of 1.7% in July from 1.4% to mark the highest reading since November 2008, and mounting price pressures could lead the Governing Council to drop its dovish outlook for future policy as it maintains its one and only mandate to ensure price stability. On the other hand, tightening fiscal policy paired with the ongoing slack within the domestic economies could drag on the recovery and weigh on price growth going forward as ECB President Jean-Claude Trichet expects to see an “uneven” recovery going into the following year, and the central bank may look to maintain its current policy throughout the remainder of the year as the governments operating under the single-currency struggle to manage their public finances and take unprecedented steps to lower the budget deficit.

As a result, the ECB is widely expected to hold the benchmark interest rate at 1.00% in August, with investors pricing a zero percent change for a rate hike according to Credit Suisse overnight index swaps, and the Governing Council is likely to keep its exit strategy on hold as it aims to balance the downside risks for the region. Accordingly, the Q&A session with President Trichet is likely to spark increased volatility in the exchange rate as currency traders weigh the prospects for future policy, and market participants are likely to direct questions regarding the results of the stress test in order to shed increased light on the overall situation of the European banking system.

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