Euro Forecast: EUR/USD Decline May Not Be Finished

Fundamental Forecast for EUR/USD: Neutral

- The Euro depreciated against all of the other seven major currencies, with EUR/CHF (-1.64%) and EUR/USD (-1.45%) leading the decline.

- The preliminary May Eurozone PMI readings aren’t set to improve, giving little reason for the Euro’s downtrend to end.

- The IG Client Sentiment Index is once again suggesting to sell EUR/USD after recent shifts in speculative positioning.

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The Euro was the worst performing major currency last week, with EUR/CHF (-1.64%) and EUR/USD (-1.45%) leading the decline. A revision lower to the final April Eurozone CPI report coupled with signs that the United States would avoid significant trade disputes with China sapped demand for the low yielding Euro.

Concurrently, the fundamental backdrop for the Euro remains rather weak. The Citi Economic Surprise Index, a gauge of economic data momentum, closed last week at -91.7, still deep in negative territory (although no longer at its weakest reading since September 2011). This is a slight improvement from a week ago (-97.9) but not over the past month (-90.0).

Inflation expectations aren’t doing much better than data momentum, both of which have been steadily eroding in recent weeks. The 5-year, 5-year inflation swap forwards finished Friday at 1.702%, down from 1.714% a week earlier. Inflation expectations peaked this year on January 22, when the 5-year, 5-year rate was 1.774%.

It would seem that this would be as good as a time as ever for inflation expectations to turn higher (if they intend to in the near-term), given that Brent crude oil prices having been rallying and Euro strength isn’t as pronounced as it once was (Euro trade-weighted index is only up +4.77% from a year earlier; a month ago, it was closer to +9%).

The week ahead promises few opportunities for the bearish narrative that has enveloped the Euro over the past several weeks to disappear. Externally, any resolution to the purported China US trade war would seemingly be US Dollar positive, mirroring the initial negative reaction to when the trade cooperation became strained.

Internally, the only significant data due out are the initial May PMI readings. The mix of individual country releases at the start of the week will culminate in stagnant readings in the cumulative Eurozone PMIs due out on Wednesday (no change or declines are anticipated). Elsewhere, political risk is on the rise now that Italy has a new government: Italian bond yields and credit default swap spreads have been rising since the news broke in early-May.

Lastly, there is still a notable net-long Euro position in the futures market. Speculators still held +115.1K contracts through the week ended May 15, a -24% decline from the all-time high set during the week ended April 17 (+151.5K contracts). While this is becoming a less difficult a situation for the Euro, the path of least resistance for the Euro remains towards weakness if positioning trimming continues.

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--- Written by Christopher Vecchio, CFA, Senior Currency Strategist

To contact Christopher, email him at cvecchio@dailyfx.com

Follow him in the DailyFX Real Time News feed and Twitter at @CVecchioFX.