Fundamental Forecast for the Euro: Neutral

There’s still a financial crisis simmering in Europe. Yet, with all the market headlines from the past week, it is almost possible to forget that the Euro-region is still struggling to halt the spread of fear that a technical (or not so technical) default from Greece could trigger a full-blown disaster for the shared currency and its monetary union. Scanning the fundamental landscape to determine what roads the euro has to follow, it is clear that we are facing a period ofheavy volatility; but direction is dependent upon what developments grab the headlines and is therefore unpredictable.

For those trading the euro, the first concern should be EURUSD. Though this is only one pairing for the shared currency; it is the FX market’s most liquid cross. Strong movements in capital through this particular exchange rate often guide movement for the euro against all its counterparts. That said, euro traders should tune in to the US budget deficit spectacle along with the rest of the world. The country has struggled to push through a necessary boost to its legal budget ceiling along with a viable plan to lower the burgeoning debt going forward. No resolution on either points after the August 2nd expiration could cause more financial turmoil than straightforward dollar selling. A temporary fix could offer a temporary reprieve for the dollar and bounce in risk appetite; but the euro’s primary benchmark will struggle to gain traction. Under a meaningful fix, capital could once again rush back into the US (especially from Europe) and the adopted plans to cut back on US stimulus can add an eventual risk aversion move that would further hurt the euro.

In the meantime, the health of the Euro Zone’s markets will compete for headlines. This past week, Greece was downgraded by both Moody’s and Standard & Poor’s as the ratings agencies converge on the opinion that the restructuring effort that the EU has agreed upon would consistent a temporary default. That said, the ISDA (the group responsible for determining whether a default event has taken place and swaps should be paid out) has indicated that it would not trigger CDS on the program. This could significantly reduce immediate losses on Greek exposure; but the mark will have been made. From the euro’s standpoint, however, the market has already given a lot of room for further problem. The real threat comes should the infection move closer to the core. After Moody’s put Spain on review for a possible downgrade into the end of the week, the market was reminded that the strain is building for Portugal, Ireland, Spain and event Italy.

The financial troubles the Euro-area faces are come with very real economic consequences as well. With austerity efforts in full effect for the periphery, we are watching to see how big of a hit the most troubled economies take going forward. In the meantime, we will need to also see how the larger member are faring with a more natural downturn in global, regional and domestic activity levels. Our litmus test will be the first reading of 2Q GDP figures from Italy. Coming out well advance of its peers and measuring the health of a critical economy in the EU structure; this will be one to watch.

And, just to remind us that this is not just about finding which currency is the best of the worst; we will also have an update on the return side of the equation. The ECB rate decision is scheduled for Thursday. Economists are unanimous in their expectations for a hold at 1.50 percent; but the market seems to be pricing in a 62 percent chance of a 25 bps hike –but that may be a side effect of the unusual risk influences we’ve seen recently. We’ll be looking at ECB President Trichet’s commentary specifically. At the last meeting, he dropped the ‘strong vigilance’ phrase that the market attributes to a coming rate hike. We’ll see if any distinct cues make their way in this time.

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