Rate rise in euro would expose weak periphery

Philip Salter
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MARKETS are expecting a quarter point rise from 1 to 1.25 per cent when the European Central Bank (ECB) meets tomorrow. However, even if Jean-Claude Trichet, president of the ECB, announces the quarter point rise, the euro could still come under pressure, as attention focuses on the impact of higher interest rates upon Europe’s beleaguered peripheral nations.

Regardless of what happens, it’s bad news for euro bulls. If the ECB doesn’t raise rates then the euro is bound to weaken on the back of the surprise. Richard Wiltshire of ETX Capital firmly believes that a quarter point rise is already priced in, while Richard Nehme of International Foreign Exchange believes that “Trichet’s comment of “strong vigilance” has generally been accompanied by tighter monetary policy in the past.” With German inflation at 2.2 per cent the ECB has been coming under pressure from the continent’s powerhouse to act. In the UK we are becoming accustomed to inflation significantly above these levels, but in Germany where the economy is in recovery mode and unemployment is falling, the memory of hyperinflation still bears a scar.

Lorenzo Bini Smaghi, member of the ECB’s executive board, Axel Weber, president of the German Bundesbank, and Trichet have been dropping hints that the ECB is prepared to raise rates. As such, a key component of tomorrow’s rate hike will be “how hawkish or otherwise Trichet is in his post meeting press conference,” says Michael Hewson of CMC Markets. The question for Hewson and other traders is: “Is this a one-off, or will he continue to peddle the strong vigilance tone of last press conference?” A hike, hawkish comments, or a market keen to probe the upside could see the euro strengthen initially, but things should drift back to current levels, says Wiltshire. Angus Campbell of London Capital Group thinks “it could be a classic case of buy the rumour, sell the fact, as the euro has strengthened so much recently. Once the fully expected rate hike is announced we might see a bit of weakness.”

The ECB is stuck between a rock and a hard place. Under normal conditions, a hike in the base rate results in a strengthened currency, as higher yields make that economy attractive to investors. However, these are far from normal conditions. The extremities of the monetary union are diseased by debt after years of fiscal profligacy. As yet, politicians have lacked the gumption to impose the right medicine, while citizens have been too timid to take it. In contrast, the heart of the union is looking comparatively healthy, but the German public is increasingly unwilling to shoulder the burden of keeping the Euro-leviathan alive – this includes shouldering inflation. Unless the periphery gets to grips with debt, amputation is an option.

A currency that will go down no matter the decision of the central bank is overvalued. Hewson agrees: “The euro is overvalued and will weaken especially if they hike rates, as it will make a default scenario much more likely in the periphery, and also bring Spain into focus.” Low interest rates stoked the asset bubbles that burst on the periphery of Europe back in 2008. Now raising rates will put their economies and the future of the monetary union itself to the test.