Euro Balancing The Influence Of Bailouts And An Expected ECB Rate Cut

Fundamental Outlook for Euro: Bearish

-   European Union announces its own 200 billion stimulus package
-   German GDP numbers confirm a recession for Europe’s largest economy
-   Euro Zone CPI estimate drops quickly back in line with ECB target

The euro is at a cross roads and the US dollar is a perfect fundamental and technical counterpart for the single currency. Risk trends, growth, interest rates and bailout efforts between these two economic superpowers will soon redefine the long-term trend of the Forex market’s most liquid currency pair. Wading through all this uncertainty, the most concerning piece of scheduled event risk (in an otherwise crowded economic docket) is the European Central Bank’s rate decision due Thursday morning at 12:45 GMT. On the bank of last month’s substantial cut, the policy board is expected to lower the benchmark another 50 basis points to help recharge growth, stabilize the financial markets and prevent a possible deflation scenario. Looking at the fundamentals that would play into the rate decision, the door is certainly open for President Jean Claude Trichet and his fellow policy makers to take more aggressive action. This past week, GDP numbers confirmed a recession for the Euro Zone’s largest economy, unemployment and activity numbers are pointing to a deepening slump going into year’s end, and the advance CPI indicator plunged to just 0.1 percent of the central bank’s target from the previous reading of 3.2 percent. Few would argue with the ECB if they decided to mimic the BoE’s massive cut last month.

Interest rates will play a key role in price action over the next few months and over the next few quarters. Over the coming months, the global recession is expected to intensify, which will keep interest rates trending lower. As such, there will be little interest in trying to reestablish any carry positions as risk will be to great. This means that speculation for the European monetary authority to lower its benchmark lending rate will hold. Whether the easing will be aggressive or steady will define the euro’s strength. Looking ahead to the ECB’s decision, a smaller than expected cut (or no cut at all) could leverage the short-term rebound in EURUSD and help genuinely turn the market on the belief that European assets will come out of the current global credit crisis and growth slump with higher yields that could draw capital away from the safe confines of US boarders. On the other hand, a bigger than expected reduction (a la the BoE) would be another sign that the Euro Zone is further behind the curve than the US. This could be the best fundamental driver for a drive below 1.23.

Another consideration for fundamental trends next week will be the relative health of Europe’s economy and financial markets. During periods of global expansion, investor tend to direct their capital to those areas will growth is strongest and most consistent. When in a broad recession, those funds move towards those economies contracting the least and look as if they will reverse first. The second reading of Euro Zone growth will determine whether to expect a deepening recession or if the economy may level off with a modest slump. As for the markets, the efforts made by the European policy authorities have certainly lagged those made by their American counterparts. We still need to judge the effectiveness of the stimulus package announced by the Euro-Zone last week; but considering the lack of direction for those funds and the incredible need, officials will likely have to come up with far more money to put the Euro Zone back on track. – JK

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