Fundamental Forecast for Euro: Bearish

If we were to do an objective analysis of the euro, it would be difficult to formulate an argument for a bullish outlook in the data and headlines we have been shown over the past few weeks. The economic docket is lacking for influence altogether. Far more influential are the nearly daily hits the region’s financial health seems to take. Downgrades, fiscal miscues, halted progress towards fixing underlying issues with the monetary union have crowded out the headlines. And yet, the euro not only maintains its buoyancy; it has extended its climb against key safe haven and speculative currencies alike. What then is the source of the currency’s strength? Speculation. The FX market doesn’t exist in a vacuum; and expectations are a greater source of activity than prevailing fundamentals. Point-in-case is this week’s ECB rate decision. Speculation surrounding this particular event has solely defined the currency’s performance; so what happens when we are actually confronted with its release?

There are a few things we should consider when approaching a scheduled economic event: how market-moving will it be; can it carry a full-blown trend and what are the scenarios. First off, we need to assess its potential impact. For the past two years, ECB policy meetings were altogether overlooked by market participants. With no change to policy and no change to rhetoric; there was little to work with. That all changed this past month however when ECB President Trichet upped the ante when he signaled a hike was likely on April 7. This has clearly caught the interest of the market to the point where contradictory fundamentals are overlooked to focus on the target release. That level of absorption virtually guarantees volatility as traders have put so much stock into the event that vindication, disappointment or surprise will lead to large shift in positioning. And given the trend that preceded the event; the one following will carry a lot of weight.

For scenarios have to consider the stakes. Heading into this new trading week, we see the market is pricing in a 131 basis points (bps) worth of rate hikes over the coming 12 months and show an absolute certainty of at least a 25bp hike at the forthcoming decision (and an additional 44 percent chance that it will be a 50bp). Over a year, five quarter-percent rate hikes is somewhat aggressive; but not too far out of the realm of possibility. The building expectations of a possible 50bp hike this week, however, may be asking for too much given the wave of financial troubles that have washed over the Euro Zone. That raises the stakes substantially. Under such pressure, a quarter-percent hike and no immediate guidance on an aggressive rate regime would actually be seen as a disappointment.

In fact, trying to establish a bullish scenario for the euro, we would either see a 50bp hike and at significant potential in follow up moves with no interruptions (perhaps a single month’s break); or a quarter-percent jump backed by clear intentions for a steady stream of subsequent hikes. That sets the bar exceptionally high; and suggests that the risk is far greater to the downside. Should rate expectations disappoint at all; the market will quickly turn to the multitude of sovereign and banking downgrades these past two weeks; Ireland’s inability agree to terms with the EU and IMF to stabilizes its finances; Portugal’s path towards a bailout; and other critical factors that undermine the very stability of the euro.

So, while we could very well see a bullish outcome to the ECB decision; the risks associated to the alternative scenario are so great that such a move carries far more weight. What could add another layer of complexity to the mix is if the market tries to force a euro move before the event.

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