The European Central Bank's shock message that interest rates could rise soon has sparked a rally in the euro and could push it to fresh record highs against the dollar as investors reassess the outlook for euro zone yields. The ECB held rates at 4 percent on Thursday, but kicked the door wide open to a rise as soon as next month.
This would increase the rate advantage the euro holds against the dollar, whose rate has fallen to 2 percent following an aggressive policy easing campaign by the Federal Reserve.Analysts say that escalating speculation of such a move by the ECB may prompt traders to cut bets on the dollar made earlier this week after comments from Fed Chairman Ben Bernanke highlighting inflation risks bolstered the view that US rate cuts have ended.
The unexpectedly hawkish commentary from ECB chief Jean-Claude Trichet on Thursday will likely cause investors to move back into the euro, which has retreated from a record high of $1.6018 set in April. "Institutional investors are now significantly long US dollars as they anticipated the rate differential moving in favour of the dollar," said Michael Metcalfe, senior strategist at State Street.
"My worry is that this surprise move from Trichet shows institutional investors may have things the wrong way around, and that a rate rise from the ECB may cause them to unravel dollar longs." He said if the market's focus returns to concern about the extent of inflationary pressure rather than dipping growth, this could lead the euro to race as high as $1.65 after a rate rise from the ECB.
Trichet's comments have put the prospect of higher euro zone rates at the front of investors' minds as it would be giving the single currency the boost of a growing yield advantage over the dollar. "As long as European data is not screamingly bad the debate about the timing of rate hikes will be on the front burner which will be a catalyst for euro strength," said Simon Derrick, senior currency strategist at Bank of New York Mellon.
He said he sees a possibility the euro will reach new record highs against the dollar above $1.60 over the summer but thinks it will perform even better against the pound reaching around 82-83 pence with the Bank of England likely to cut rates.
Trichet's comments snuffed out a brief bout of dollar resurgence against the euro which was triggered after Bernanke said that inflation expectations were a significant concern for Fed policymakers and a weak dollar was adding to price pressures.
The ECB flagging a policy that is likely to put downward pressure on the greenback signals a departure from a more co-ordinated stance in the past among major central banks against dollar weakness.
However, some analysts think the dollar's slide will be limited by a return to a more cohesive message on the dangers of dollar weakness from finance officials when they meet later in the month. "I do not think, despite the widening in spreads with the US, that euro/dollar is going to make new highs," said Nick Parsons, head of market strategy at nabCapital. "I think going into the G7 finance ministers' meeting there will be a sustained effort on the part of the politicians and finance ministers to be talking down the euro/dollar."
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