Euro Forecast at Risk Ahead of European Central Bank Rate Decision

Written by David Rodriguez, Quantitative Analyst

Euro Forecast at Risk Ahead of European Central Bank Rate Decision

Fundamental Outlook for Euro This Week: Bearish

- Dismal German GDP data sends euro to bottom of trading range
- German IFO economic sentiment falls to fresh record low
- Forex trading markets next look to European Central Bank rate decision

The Euro traded lower against the US dollar on an incredibly volatile week of trade, but the true fireworks are likely to come on a heavy string of economic event risk in the week ahead. Both the Euro Zone and the US economy have a key number of reports due within a short span, and markets are likely to force substantial moves in the Euro/US Dollar on any unexpected developments. Overall FX market momentum supports further euro losses and US dollar gains. Yet it will be important to watch any potential shifts in the week ahead.

Intense intraday volatility in the Euro/US Dollar could intensify on the coming week’s critical European Central Bank interest rate decision and several other second-tier releases. Consensus forecasts call for the ECB to cut its benchmark interest rate by 50 basis points to fresh record-lows of 1.50 percent, but uncertainty surrounding the event means that markets will force euro volatility regardless of the outcome. Overnight index swaps (OIS) currently price in a dead-certain 25 basis point cut and a 50 percent chance of a full 0.50 percentage point move. Regardless of the outcome, markets will pay very close attention to ECB President Jean Claude Trichet’s Question and Answer session following the announcement. The typically candid central banker already telegraphed a March rate cut in the same Q&A session following the January move, but questions remain as to whether the ECB will truly continue cutting rates to record lows. If there is any indication that the ECB will set an effective floor on its benchmark rate target, the euro would likely benefit vis a vis the low-yielding US dollar.

The euro will otherwise trade off of further financial market and macroeconomic developments—especially as they relate to Euro Zone stability. Wide European sovereign debt spreads underline the state of unease for many member countries, and ongoing fears of political fallout from the financial crisis bodes poorly for the euro itself. Recent rhetoric suggests that Germany and other major economies stand ready to bail out those countries at risk. Traders have nonetheless punished the euro for perceived instability, and any further deterioration in EMU affairs could send the EUR even lower against major counterparts.

US Dollar Testing 3-Year Highs as NFPs and Nationalization Loom

The world’s most liquid currency ended the week in a precarious technical and fundamental position. For those watching the charts, the Dollar Index closed Friday just off a three-year high. And, making sure to keep market participants engaged until liquidity returns on Monday, fundamental traders are debating the appeal of a currency that represents a ballooning recession, a market-wide demand for safety and the dawn to a period of nationalization.

US Dollar Testing 3-Year Highs as NFPs and Nationalization Loom

Fundamental Outlook for US Dollar: Bullish

- The US government moves one step closer to nationalization with a 36% stake in Citi
- With global rates falling to zero and recession spreading, is the dollar is taking the top safe haven spot from the yen?
- Growth contracted more than expected and the fastest pace in 26 years according to GDP revisions

The world’s most liquid currency ended the week in a precarious technical and fundamental position. For those watching the charts, the Dollar Index closed Friday just off a three-year high. And, making sure to keep market participants engaged until liquidity returns on Monday, fundamental traders are debating the appeal of a currency that represents a ballooning recession, a market-wide demand for safety and the dawn to a period of nationalization.

Looking ahead to next week and beyond, with so many major fundamental themes evolving throughout the markets; the dollar will have decide which driver will take precedence. The most pressing (and novel) concern for the greenback is the US government’s trend towards nationalization. The stakes were raised this past Friday when it was announced that the Treasury was taking a 36 percent stake in Citi – the world’s largest financial firm. This was a blatant move by officials after a series of questionable steps towards government stewardship that includes: seizing control of Freddie Mac and Fannie Mae; taking over insurance giant AIG after extending it a $150 billion credit line; and announcing that loans from the tax payers coffers will now come with the price of convertible preferred shares from those lending. In normal markets, such a move would spark fear that investor equity could vanish and returns could be dampened. However, it is obvious that we are not experiencing normal market conditions. Global growth is cooling, returns are shrinking, risk of financial seizures is high and many of the world’s largest economies are adopting a similar policy. At this point, the government likely sees this intervention as necessary to ensuring further financial time bombs don’t revive the financial crisis and send the nation into a tailspin that it cannot pull out of; and the markets may agree.

How long the dollar can hold out as the headwinds to free-market economics increase is debatable. One key determinant for the currency is its status as a safe haven. Since the plunge in Japanese GDP numbers led investors to rethink the viability of the yen as a reliable asylum for capital, we have seen investors head towards the US dollar to purchase Treasuries and other low-risk, American assets. Clearly, this dynamic depends upon the presence of risk. There are plenty of indicators and signs to support the proliferation of fear; but ultimately this market driver is a product of sentiment. Should the balance of risk/reward invert and the S&P 500 reverse course, there is little need for a safe haven whose economic recovery will be stifled by its government’s presence.