Euro set to rise against dollar, default for peripheral countries comes closer as ECB hikes rates

ECB rate rise signals a stronger euro versus the dollar, while the Portugal crisis may bring default closer

John Vax
On 7 April 2011 13:32

The ECB, recognizing clear signs of inflation in the eurozone, has decided to raise the Euro benchmark interest rate 0.25 percentage points to 1.25%. This is the first rise in three years. 

The tightening of monetary policy is necessary since the core of Europe, particularly Germany, is growing above 3.0% and inflation has ticked up. However, on the periphery, particularly in the troubled countries of Greece , Ireland and Portugal, growth remains anemic. Since the eurozone can have only one rate, the increase in rates will put additional pressure on the peripheral economies. We believe that the rate rise (and likely further rate rises) will make the choice clearer regarding restructuring of (read "default on") the peripheral countries' debts. In other words, the sooner the restructuring comes, the better off everyone will be (except perhaps some bondholders).

The acceptance of the bailout package by Portugal today was a bit anti-climactic as everyone in the bond market had more-or-less priced in the capitulation of the Socrates government. The question now is what the terms will be of the package, particularly the interest rate on the loans. Will it be more or less harsh than the packages agreed to by Greece and Ireland ?

Despite the peripheral crisis being hailed by some as signaling the end of the euro, the big picture now suggests that the it should continue to strengthen versus the US dollar. The two currencies are clearly on divergent paths. The ECB has begun its tightening cycle while the Fed is clearly still in its loose money phase. The latest discussion suggests that there is no other way forward but an extension beyond June 2011 of “Quantitative Easing”, a euphemism for printing money by the Fed. In other words, there is little likelihood of the Fed switching from a loose-money policy stance to a tightening one for the foreseeable future. This should be bullish on the euro and bearish for the dollar over the medium term.

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