From the September 01, 2010 issue of Futures Magazine • Subscribe!

Forex outlook: Has the euro bottomed?

The European debt crisis rocked the currency markets in the first half of 2010, sending the euro lower while investors fled to the safe haven of the U.S. dollar. Experts are split about whether the euro has hit bottom, with some predicting a comeback by the end of 2010 and others forecasting continued economic weakness in Europe that will drag the euro down further. With split opinions on the euro come split opinions on the direction of the dollar. And economic uncertainty will likely equal volatile currency markets for the rest of the year.

After the euro took a beating on the heels of severe economic weakness in the PIIG nations (Portugal, Italy, Ireland and Greece) in early 2010, Europe conducted stress tests on its largest banks in an attempt to make their balance sheets more transparent to investors and stabilize the behavior of the euro. The results, released on July 23, were positive, with only seven of 91 banks failing. This gave a boost to the currency, which had rebounded from its lows throughout July. However, among analysts, the jury is out on whether the euro has hit bottom.

Andrew Wilkinson, senior market analyst at Interactive Brokers, thinks the euro has hit bottom and that pessimism on the euro in the first half of 2010 was overdone. He adds that second quarter industrial production and manufacturing output in the Eurozone expanded, outpacing demand in the United States and playing a role in boosting the value of the euro against the dollar. He predicts the euro to be at 1.40 by yearend.

However, according to International Monetary Fund (IMF) forecasts, GDP in the Eurozone is expected to rebound in 2010 at a slower pace than other regions. The pace of economic recovery is key to where currency markets are headed (see "GDP jumping?" below).

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"Eurozone fundamentals, in terms of economic data, will improve a bit and even though their growth in individual regions is going to be zero to negative for the rest of the year, in the near-term, you’re going to see prior weakness in the euro have an impact on the data, so that should help sustain 118.77 as the bottom," says Kathy Lien, director of currency research at GFT. She says the euro should be at 1.26 by yearend.

But some say the euro is headed lower. Budget deficits have plagued most of Europe, the UK and the United States over the last few years, weighing on currencies and the broader economic picture (see "At a deficit," below). Brian Dolan, chief currency strategist at Forex.com, says the euro is undergoing a correction and is likely to see further weakness in 2010 due in part to a slowing global recovery. "The catch-22 for the Eurozone is that their deficit reduction efforts need stronger economic growth than they’re going to achieve to remove and repair the debt crisis. Their austerity measures are likely to work against economic growth. They’re on the verge of a fiscal deficit spiral," he says, targeting the euro at 1.15 by yearend.

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Dan Cook, senior market analyst at IG Markets, agrees, adding that there’s no sign austerity measures in the PIIGs are working or being implemented properly. "They had a lot of debt before and they’re issuing more backed by the European Central Bank [ECB], but how will they be able to sustain it later into the year, particularly if the ECB slows down on their measures? That’s my big concern over being too bullish on the euro," he says. "If the austerity measures start to work, which data hasn’t suggested, we could see the 130s. However, there’s still a lot of risk that could take us [down] to 1.15 or 1.10."

The pound took a nosedive in May and June and then had a major rebound throughout July. "The story for sterling is similar to the outlook for the euro," Dolan says. "Austerity measures [will] be kicking in in 2011, and the market’s going to be in the process of pricing those in, and that’s a negative for the sterling." He adds that the Eurozone and UK are at risk for seeing negative GDP in the quarters ahead, which means the Bank of England could keep interest rates on hold and weaken the pound further. Dolan predicts $1.40-$1.45 for the pound at the end of the year.

Others have a more positive outlook for the pound. "The UK [is] a more favorable growth story [than Europe]. While it has a huge budget deficit, the new coalition government has tackled it with a very stringent budget," Wilkinson says. He expects the pound to reach $1.60 by the end of the year.

Cook says the investment community is extremely optimistic about the pound. "It’ll [experience] steady growth, more of a range-bound trade between the pound and dollar, 1.48-1.58 or into the low 160s." However, he adds that if things blow up in Europe, the pound will be dragged down.

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