Euro uncertainty to continue

FRANKFURT - The uncertainty surrounding the euro's future direction is continuing, and FX market participants are split on the outlook for the currency, with 12-month forecasts ranging from $0.77 to $1.10.

In spite of growing economic gloom in the US and a series of deep interest rate cuts there, the single European currency has remained mired below the $0.90 level. For much of last year, however, speculation had been that the euro would recover once the all-powerful US economy cooled its 10-year growth. Following 275 basis points of Federal Reserve interest rate cuts, the market's view is now fixed firmly on whether the world's number one economy will ride out the storm, and the euro could be set for further losses in the mid-term, some analysts said.

"We have always been bearish on the euro, and for the next three months I think we will see further indications that the US economy is stabilizing, while the eurozone remains in a quagmire," Jane Foley, currency strategist at Barclays Capital in London told FX Week. "Real rates of return should continue to be higher in the US and the money will continue to head in that direction. We don't see anything that will change that trend."

US recovery
The market's unflinching confidence that the Federal Reserve's aggressive stance on monetary policy will prompt a recovery of the US economy, as well as the continuing flow of investment capital from the eurozone to the US, has given the dollar an invincible air recently. The European Central Bank's continued focus on price stability, and perceived lack of attention to economic growth, has led some observers to suggest that the euro has missed the boat. However, not all analysts agree.

"The eurozone has got particular problems with growth being downgraded, but there is not enough momentum to suggest an aggressive move down anytime soon," said Jeremy Stretch, currency strategist at RBC Dominion Securities in London. "As we approach the start of next year, we may have seen some ECB rate cuts, perhaps to 4%, and growth numbers should begin to look a little more healthy. Then perhaps investment flows away from the eurozone will slow."

Official figures from the European Central Bank showed that foreign direct investment (FDI) flows out of the eurozone are starting to slow - from EUR4.5 billion in January, to inward flow of EUR0.1billion in April. However, FDI has only been in positive territory in one month since the euro's inception.

Lack of return
Another issue likely to hamper the euro's progress in the long term is the lack of economic reform in the eurozone. With 12 distinctly different economies, all with vastly different protocols on matters such as tax and employment, the path to workable monetary union requires reform. Germany has taken some steps towards tax reform, but concerted reform throughout EMU is likely to mean a period of economic pain before the benefits feed through to the euro.

"The lack of reform in Europe and light at the end of the tunnel for the US will se the euro head for new lows in the long-term after a rise in the medium term," James Shugg, senior economist at Westpac Banking Corporation in London told FX Week. BarCap's Foley agreed.

"The US has a very flexible labour market but in Europe reform is quite unlikely," she said. "That alone implies that long-term productivity rates will be higher in the US."
The final fly in the euro's ointment is the European Central Bank. The bank has been attacked by politicians, market participants and investors over its reluctance to cut interest rates, and lack of credibility in its communications with the market.

Some analysts have accused the ECB of pursing its mandate to preserve prices in the eurozone at the expense of economic growth, which has been downgraded several times this year.

"I don't think the European Central Bank's actions have harmed eurozone growth as much as some people say," Westpac's Shugg said. "The euro has certainly suffered, but growth itself is being held back by other issues such as the lack of reform. The bank does deserve criticism for the way it communicates with the market, but cant be blamed for growth."

Lack of transparency
RBC's Stretch agreed, highlighting the lack of transparency in the bank's decision making."On one level the bank seems to have a one-eyed approach to monetary policy and on another it seems to have a perennial inability to manage monetary policy effectively," he told FX Week. "One hopes the bank will learn from its mistakes and perhaps be a little more like the Bank of England's monetary policy committee - but that seems some way off at present."

Although the market looks likely to remain split over where the euro will finish the year one thing seems clear - the currency is unlikely to become master of its own destiny anytime soon.
Meanwhile, the euro rose sharply against the pound last week after pro-euro ex-chancellor of the exchequer Ken Clarke took the lead in the race to lead the Conservative party in the UK. Dealers said it is now possible all three leading parties could support UK euro entry. Sterling must, however, be weaker than current levels to join.