Fundamental Forecast for the Euro: Bearish

Continued US dollar weakness pushed the euro/US dollar pair higher for the third week in four, leaving the single currency just short of the 1.50 mark in what promises to be an exciting week of trading. Markets anxiously await results from Tuesday’s US Federal Open Market Committee interest rate announcement and Wednesday’s German Consumer Price Index inflation data. The FOMC is exceedingly unlikely to raise interest rates, but markets will keep a close eye on ensuing commentary and the first-ever FOMC press conference by Chairman Ben Bernanke. German inflation figures will likewise factor in European Central Bank interest rate expectations, and any noteworthy surprises could force substantive moves across all Euro currency pairs.

A noteworthy pullback in ECB rate forecasts warns that interest rate-driven demand for the euro will slow, and focus remains almost solely on whether the downtrodden US dollar can continue lower on flagging FOMC monetary policy expectations. Overnight Index Swaps showed 12-month European Central Bank interest rate hike expectations as high as 140 basis points less than two weeks ago. Yet those same OIS now show forecasts at nearly half their peak at a modest 80bps through time of writing. ECB expectations represent a significant advantage a paltry 36bps for the US FOMC, but the gulf in expectations has narrowed significantly on a wave of softer European economic data. Upcoming German Consumer Price Index data is expected to show year-over-year inflation of 2.4 percent through April. Any significant surprises could force commensurate corrections in ECB rate expectations and the euro itself.

Markets have largely ignored recent developments surrounding Greece, Portugal, and the broader Euro Zone sovereign debt crisis. Yet the lack of interest rate support could once again lay bare the tensions surrounding Euro Zone stability. To that end, there has been chatter surrounding the possibility of a Greek debt restructuring (i.e. default) as early as this weekend. The generic Greek 2-year government bond currently yields a stunning 23% according to Bloomberg composite data. Such usurious interest rates underline the lack of confidence in Greece’s ability to repay debt, and restructuring seems almost a foregone conclusion.

The euro nonetheless remains well-bid despite the obvious tensions in debt markets, and the key remains whether tensions in Greece and Portugal spread to Spain—the single currency zone’s fourth-largest economy. The spread between the 10-year Spanish Government bond yield and the benchmark German issue currently stands near its widest since the inception of the euro. Traders should keep an eye on whether further Greek and Portuguese debt troubles cause further contagion to the much-larger Spanish economy, as fears over Spanish solvency could force considerable corrections in the EURUSD. On the other side of the trade, it remains critical to listen to US FOMC rhetoric in the week ahead. Key event risk promises important EURUSD volatility in the week ahead.

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