Fundamental Forecast for Euro: Neutral

The euro surged this past week -- fully recovering the substantial losses of the opening week of the year. It is difficult to separate the impact that the unusual liquidity conditions had in this scenario from the true fundamental developments. However, the events that have transpired so far this year certainly warrant the level of activity we have seen. When traders first returned to the market, they picked up on the same concerns about a deteriorating financial backdrop for the Euro Zone that they had left off with in 2010. Perhaps noticing the gravity of the situation and the futility of policy officials voicing optimism in the public forum; the heads of state finally stepped up to the problem with an open-ended discussion of drastically expanding the EU’s efforts to quell a crisis in the region. And, taking it a step further for the euro, the ECB finally seemed to turn the corner on its neutral policy stance to finally start talking interest rate hikes. The week ahead will be critical as it will tell us just how much influence each of these developments can carry through speculation alone.

It would certainly be remarkable if the EU passed a range of policy steps to expand its stimulus efforts and the ECB started to lift the benchmark lending rate in quarter point steps. In fact, if that were to happen; the euro would surge. And, really, even a strong belief that either or both of these events could occur in the near term would drive the shared currency to new highs. However, are these bullish objectives actually credible? First we start with the more complicated proposals supposedly being debated by European officials. Among the points being discussed are an expansion of the EFSF bailout program, lower rates to access the emergency funds, additional guarantees, the ability to intervene in the bond market, a direct line of credit to Portugal, the purchase of Greek bonds and other enticing endeavors. Again, if all of these were passed; it would be a significant relief from the perceived threat to the region. Yet, why should we believe these are realistic measures that will be taken when there has debate over much smaller points. What’s more, does this solve the problem of recessions in some EU member economies and the cost incurred by others? No. The market will be quick to recall this fact should the summit this coming week doesn’t produce any tangibles. An estimate of a real results not coming until March sets a realistic time frame.

As for the probability of an ECB rate hike, President Trichet said quite clearly that interest rates were “appropriate” at the outset of his discussion. And, though he noted the risk that near-term inflation could climb; he didn’t explicit voice concern about medium-term inflation. Independence is important to the major central banks; and they will express this freedom by suggesting they are willing to fight inflation even when there is a fiscal and economic struggle at hand. However, raising rates in the EU would severely burden member economies that are already truly struggling. Knowing this, policy officials are very unlikely to act on price pressures that are largely centered on food and fuel costs. So while further jawboning inflation may keep the euro buoyant; reality will soon set in.

The two major themes mentioned above will almost certainly define the euro’s path going forward; but it is the market’s assessment of their development that ultimately matters. For that, we should keep a close eye on underlying risk appetite. If investor optimism rises, they will be more prone to believing the bullish chatter; and pessimism will lead traders right back to the underlying problems. As for the economic docket, the focus actually lies on sentiment. Consumer and business optimism will paint the economic picture; but it is the ZEW investor survey that is really interesting. This is polling those that are actually buying European debt.

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