Fundamental Forecast for the Euro: Neutral

It is difficult to separate the euro’s strength from the dollar’s weakness. Considering EURUSD is the most liquid currency pair (by a wide margin), the steady pressure on the greenback is a natural source of strength for the European currency. However, looking across the euro crosses, we still see much of the same thing –a stable or appreciating currency. This strength is remarkable not just because of its pace; but also the fundamental headwinds it seems to be confidently traversing. Last week, there were a few notable economic releases on the docket (German retail sales and employment statistics among them); but nothing that meaningfully shifted the euro’s risk/reward balance. The outlook for yield potential is the euro’s greatest asset and the preoccupation with rates is the critical ingredient for further strength. Will the market keep its focus on the region’s higher returns; or will financial concerns bleed in and label the currency overbought?

The interest rate outlook is the primary concern this week as the European Central Bank (ECB) is set to reconsider its monetary policy approach on Thursday. The last meeting on April 7th was extraordinary as it marked the first hike by the policy group in nearly two years. This 25 basis point boost to the overnight rate vindicated speculation that the ECB would move quickly ahead of its counterparts with its return to a ‘normal’ monetary policy. Yet, since the rate was boosted to 1.25 percent; we have seen the hawkish crowd quiet sharply. In this event, we have seen a clear case of ‘buy the rumor, sell the news.’ Leading up to the April decision, the market moved quickly to bid the discounted currency to bring it up to par with a rate hike; but the subsequent momentum drove expectations far beyond what is reasonable given the fundamentals the central bank has to work with. And, interestingly enough, it was the rate hike itself that led the market to reconsider the forecast it was pricing in.

From an April 11th high of 141 basis points, the 12 month interest rate outlook has been nearly halved. Yet, in the drop in rate expectations (now pricing in three quarter-percent hikes by this time next year), we have not seen a proportionate decline in the euro’s position. That is because where the future potential for return has eased back in its support for the currency, risk appetite itself stepped up. When the market as a whole is not concerned with pending threats to market activity, traders pay greater attention to the yield to be made. As such, the significant spread the euro maintains against the dollar, pound and yen has lent the currency additional strength. That said, the euro finds itself fully dependent on a general state of optimism holding capital markets buoyant along with the belief that the rest of the currency market will not close the yield gap European investments enjoy.

Heading into the ECB rate decision, the Bloomberg consensus shows a unanimous forecast for no change to the benchmark and overnight index swaps show expectations for the same. Despite this common outlook though, it doesn’t seem the market fully appreciates the downshift in rate potential. Confronted with an actual hold and tempered expectations from policy officials could turn the market’s focus to the region’s financial troubles. If that is the case, we have concerns that Greece is on a path to restructuring, Portugal may not receive its bailout in time, Ireland delivers haircuts to senior bond holders, and Spain joins the bailout club amongst other scenarios.

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