Euro traders ignore warning signs

April 7, 2011, 7:47 PM UTC

Europe may be lurching toward another crisis, but you’d never know to look at the foreign exchange markets.

The euro held firm against the dollar Thursday after an eventful 24 hours on the Continent. Portugal on Wednesday became the third country to ask the European Union for cash to pay its bills, and this morning the European Central Bank raised its benchmark interest rate by a quarter-point for the first time in three years.

Who gets hit first?

Neither development will help the already anemic growth outlook in Europe, where export powerhouse Germany is going strong and everyone else is struggling to keep up.

But the euro continued to trade near its high of the past year, hanging around $1.43, as the prospect of higher interest rates on euro accounts drew funds out of the dollar and the Japanese yen.

“The ability of the foreign exchange market to ignore peripheral Eurozone nations’ fiscal problems is mind-boggling,” writes Societe Generale currency strategist Kit Juckes.

For now, currency traders are paying little heed to signs that Europe is headed for a reckoning of its structural problems. Those included slow growth, persistent deficits and high debt in weaker economies, along with a lack of political will in stronger economies to cobble together a lasting solution before these chronic ills turn acute.

For now the euro remains strong in part because of the ECB’s decision to raise rates, and a hint in central bank chief Jean-Claude Trichet’s comments that further monetary tightening is coming down the line, thanks to inflation rising above the bank’s target.

The ECB’s policy statement Thursday “did state that the bank would continue to monitor ‘very closely’ all developments with respect to upside risks to price stability,” notes IHS Global Insight economist Howard Archer. “This is a term that the ECB has sometimes used in the past to indicate that a further interest rate hike is on the horizon.”

Should the ECB continue to tighten policy, the interest rate differential on funds held in Europe will continue to grow over those held in the United States and Japan, where short-term rates are being held near zero.

Japan, of course, has its hands full dealing with last month’s earthquake and tsunami and its ongoing nuclear disaster. And while the United States isn’t exactly on the brink of a crisis, the prospect of a government shutdown highlights the distressing lack of progress on the country’s mammoth fiscal problems.

However the Beltway’s budget gridlock resolves itself, the assumption is that government spending here is going to get squeezed. This will nudge the Federal Reserve to keep policy loose, not that it probably needs much nudging.

“As the sides bicker about how to cut the deficit it is clear tighter fiscal policy is coming and a soft dollar will be needed to compensate,” says Juckes.

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