DailyFX.com - Flashbacks of 2010-2012 Haunt the Euro but Systemic Issue Unlikely

Fundamental Forecast for Euro: Neutral

- The biggest threat to the Euro remains what happens outside of the Euro-Zone.

- Technical outlook weakens as daily EURJPY, EURUSD Slow Stochastics, MACD point to potential sells.

- Have a bullish (or bearish) bias on the Euro, but don’t know which pair to use? Use a Euro currencybasket.

The European Central Bank’s holding pattern continues to keep the Euro constrained, with no gains or losses exceeding +/-0.85% versus any of the major currencies covered by DailyFX Research over the past five days. EURUSD barely advanced by +0.10%, closing the week at $1.3608 from its prior close at $1.3595. While the low volatility environment may make these results unsurprising, in the face of an ECB meeting, the June US Nonfarm Payrolls report, and the June FOMC minutes, one would have anticipated more substantial price action.

Instead, market participants continue to trade in a dull ‘wait-and-see’ mode around central bank policy, which as we discussed last week, will be the most significant (if not the only) driver in the major currencies over the coming weeks. As the ECB begins to fine tune its dovish policy machinations, both the Bank of England and the Federal Reserve have expressed increased willingness to wind down the non-standard, crisis containment policies that began in 2008.

As we saw this week, however, it’s going to take more than commentary from the BoE and the Fed to get the market to truly buy into the idea that interest rate hikes could be around the corner sooner than people think (a sentiment expressed in recent days by BoE Governor Mark Carney as well as Fed President Dennis Lockhart). So why no exceptionally bullish reactions in the British Pound and the US Dollar versus the Euro? Perhaps forward guidance is actually working. (Which is also why it may be a better idea to use a currency basket to express an opinion on the Euro right now).

Forward guidance has been asserted as a way for policymakers to display their intentions to keep interest rates ‘lower for longer’ as the broadly feeble recoveries in the Western economies in the post-2008 world leaves little confidence that these once-economic stalwarts can stand alone, without QE, in the future. Consider the market’s incredible faith in central banks – be it expressed by low and falling bond yields, continued upward pressure in global equity markets, or low volatility premiums – and traders very-well may be ingrained with the idea that rates are indeed staying low for the foreseeable future.

This week the market’s faith in the central bank backstop, especially in Europe, was put to the test, when Portuguese bank Espirito Santo ran into issues with servicing its debt, sending chills throughout markets reminiscent of conditions from 2010 to 2012. While risk-correlated assets sold off mid-week (Italian, Spanish, and Portuguese bonds across the curve were hit lower), the knock-on effect to the Euro was limited to say the least. In fact, as pointed out earlier, EURUSD closed the week higher around these news – and that’s after the strong June US NFPs and a June FOMC minutes that outlined the Fed’s plan to accelerate QE tapering in its last month.

We can thus declare that systemic issues, contagion, should not be resulting from this latest flare up out of Portugal. This isolated incident speaks to the weak nature of the Euro-Zone banking system in general, but that’s an issue currently being addressed as the ECB conducts its stress tests (AQR) as it prepares to take over supervisory role of the Euro-Zone banking system in November.

Just like traders refusing to bid up the British Pound and the US Dollar on expectations for higher rates, traders are refusing to offer the Euro lower on expectations of a revival of the Euro-Zone debt crisis. Forward guidance is working – it also means that market participants are complacent and only something truly shocking will release the market from its low volume, zombie-like state. –CV

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Forex pairs in this Article » EUR/USD, EUR/CHF, EUR/JPY, EUR/GBP, EUR/CAD, EUR/AUD, EUR/NZD

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