Fundamental Forecast for the Euro: Bullish

Substantial financial market volatility left the German DAX nearly 30% off of multi-year highs, but the surprisingly resilient euro squeezed out modest gains against the fast-falling US Dollar. Clear turmoil in the European banking sector and a sudden focus on France’s sovereign credit rating should have arguably been enough to sink the single currency. Yet its refusal to budge suggests there may be little in the way of further EURUSD strength.

Traders seemed intent on finding the next weak link in the Euro Zone chain, zeroing in on the EMU’s second-largest economy as Standard & Poor’s downgrade of the US sovereign credit rating raised questions on France’s AAA rating. Insolvency fears were previously limited to only the smallest Euro Zone nations and generally thought to be well-contained amidst unprecedented bailout schemes. Yet bond traders pushed spreads between French bond yields and the benchmark German Bunds to their widest in the Euro era—clearly placing a risk premium on French borrowing costs.

The previously unthinkable had happened; traders began questioning the solvency of a Euro Zone core nation and, by extension, the viability of the currency union itself. Swift reaction from French Prime Minister Sarkozy helped contain the fallout, and it seems likely that France will bring forward fiscal measures to bring down sizeable deficits in line with the stated EMU maximum of 3%. Yet the damage had been done, and financial turmoil in the currency bloc was enough to send domestic banking stocks sharply lower.

The key question for forex traders is obvious: why wasn’t this enough to sink the euro? Traders seem less and less sensitive to ongoing fiscal stresses across the currency bloc, and we wonder what might actually drive the EURUSD lower. Of course, the US Dollar has its fair share of fundamental dangers and the real question is “what’s the alternative?” The safe-haven Swiss Franc should have appreciated on a dismal week for financial markets and clear euro zone stresses. Yet effectively negative short-term interest rates and aggressive Swiss National Bank rhetoric have reduced the attractiveness of CHF bets and hedges.

We go into the upcoming week with great uncertainty and broader financial market tensions—normally a recipe for US Dollar strength and euro weakness. But forex markets remain far from normal, and the euro’s impressive resilience suggests it would take something stronger than stock market declines to force it significantly lower. A quick look at technical price patterns shows that the pair has been unable to break convincingly above a trend of lower highs dating back to May. A break of July highs near $1.45 nonetheless leaves risks plainly in favor of a run towards $1.50 and would fit within the trend of broader US Dollar losses.

The European economic calendar remains relatively devoid of major economic event risk, but traders should keep a close eye on the weekend’s Jackson Hole Economic Symposium and a scheduled speech from European Central Bank president Jean Claude Trichet. Sky-high FX options market volatility expectations predict it will be another eventful week of EURUSD price action.

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