Fundamental Forecast for the Euro: Bearish

The euro finished the week roughly unchanged against the US dollar, but late-week developments suggest risks remain to the downside on heightened uncertainty surrounding Greece and broader fiscal crises. Traders sent the EURUSD sharply lower through late Friday trade as Norway suspended its fiscal aid payments to Greece and Fitch further downgraded credit ratings for the debt-stricken government. A week of relatively limited economic event risk leaves market focus squarely on developments surrounding Greece and broader financial market trends.

Norway’s move to suspend financial aid to Greece has little tangible effect on sizeable budget deficits, but the psychological effect was clear as traders fear anti-bailout sentiment will prompt similar moves from euro zone nations. Indeed, some speculate that Finland may be the next to block aid payments amidst clear populist discontent. Fitch Ratings further fanned the flames as it downgraded Greece’s debt ratings by three notches in one fell swoop—leaving it a full four notches below investment grade and eight above default.

Fitch said the downgrade “reflects the scale of the challenge facing Greece in implementing a radical fiscal and structural reform program necessary to secure solvency and … sustained economic recovery.” The tough rhetoric underlines risk of further downgrade absent a real long-term plan to bring fiscal houses in order. Traders sent Greek government bond yields to further usurious highs, and spreads versus the benchmark German Bunds climbed to fresh records. The prospect of a Greek default remains a real risk to the euro as it could have a domino effect among similarly at-risk euro zone nations.

Traders will otherwise watch results in potentially market-moving euro zone Purchasing Manager Index, German IFO business confidence, German GfK Consumer Confidence, and late-week German Consumer Price Index inflation reports. CPI results could particularly impact interest rate expectations for the single currency.

Considerable uncertainty surrounding the magnitude and timing of European Central Bank interest rate hikes suggest any sharp surprises could produce similarly pronounced reactions out of the single currency. According to Overnight Index Swaps, interest rate traders predict the ECB will hike rates by a cumulative 95 basis points in the coming 12 months—the second-highest sum of any G10 central bank. Indeed, rate forecasts remain a key source of support for the EURUSD and risks arguably remain to the downside on disappointments.

Short-term momentum is effectively neutral as the Euro remains stuck in a wide range against the US Dollar. It will be important to watch whether the first trading day of the week sets the pace for later price action.

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