Euro Picks up after ECB's Inflation Warning

Highlights
* Bond markets ease after Portuguese and Spanish auctions
* EU wants to improve rescue fund; decision to be taken in Februaryor March
* ECB to closely monitor price developments

!! Euro Picks Up After ECB\'s Inflation Warning !!
At the beginning of the week, EUR-USD fell briefly below 1.29 - its
lowest level for several months - on fears that the impending
Portuguese and Spanish bond auctions could lead to a further
escalation of the sovereign debt crisis. But things are never as bad
as they seem: both Portugal and Spain managed to sell all their bonds
without having to offer substantial additional risk premiums;
moreover, the bid-to-cover ratios were higher, suggesting strong
interest on the part of investors.

After the Portuguese auction on Wednesday, market participants had
still remained predominantly sceptical, partly because of the
extensive bond purchases reportedly made by the ECB, and partly
because of the longer-term burden on public finances due to the high
financing costs (6.72% for the 10-year bond, 5.40% for the 4- year
issue). The result of the Spanish auction on Thursday (5 year
maturity, bid-to-cover ratio 2.1, yield 4.54%), however, was regarded
almost across the board as a sign that the tension had eased, at least
temporarily.

Reports suggesting that the EU was working on restructuring the rescue
fund, particularly the European Financial Stability Facility (EFSF),
also helped to alleviate the tension. The options under discussion
appear to be (a) extending the facility, (b) more favourable interest
terms for borrowing the funds, (c) additional ways of using the funds,
for example for the purchase of sovereign bonds. The last two points
could enable the rescue fund to come to the aid of an ailing member
state before it was on the verge of bankruptcy.

According to press reports, the German government would support the
suggestions of extending the competence of the fund and raising its
financial ceiling. German finance minister Wolfgang Schäuble did not
go quite so far in his comments. He did confirm, however, that the
eurozone countries were discussing an "extensive package" to overcome
the debt crisis; heads of government would probably decide on this at
the forthcoming European council meetings in February (4/2) and/or
March (24-25/3). But Mr Schäuble gave no opinion on a possible
extension of the EFSF's ceiling.

It was the ECB, however, which gave the euro its biggest boost,
lifting it (temporarily) to over 1.34 against the dollar. The ECB
Council confirmed its current accommodative monetary policy stance
(main refinancing rate 1%) and also its willingness to maintain full
allotment of refinancing operations. In the introductory statement,
however, in view of the recent acceleration of euro area HICP
inflation to 2.2%, the Council warned more sharply than before of
inflation risks. It is also striking that the phrase "very close
monitoring (of price developments) is warranted" appears twice in the
statement. This wording used to indicate a bias to raise interest
rates.

ECB president Jean-Claude Trichet underlined this warning by clearly
indicating the division between monetary policy stance and liquidity
management. He also referred to previous interest rate decisions
(particularly the interest rate hike in summer 2008), which proved
that the ECB gives maintaining price stability top priority.

An exit from non-conventional measures is not a prerequisite to
raising interest rates. Even if there is a liquidity glut in the
market - because, for example, due to some banks' reliance on the ECB
for refinancing, full allotment of refinancing operations has to be
maintained - interest rate hikes are still possible. All that needs to
be done is to raise the deposit facility rate, which sets the lower
limit for the overnight rate, at the same time as the refinancing
rate.

An ECB interest rate hike is not imminent in the near future, however.
At the moment at least, the ECB is still expecting the unwelcome
acceleration of the inflation rate to slow down in the second half of
the year. This estimate is feasible to a certain extent, as energy
price increases have played a decisive role in pushing up inflation.
If the oil price stabilises at its current level (which Brent futures
prices, which the ECB staff include in their price projections, seem
to suggest), the pace of inflation should slow down.

We are more sceptical, however. In comparison with many other
commodities, energy prices only rose moderately last year, mainly
because of weak demand from the US - the world's biggest consumer
country. If, as we are assuming, the economic recovery in the US
strengthens and the global economy more or less maintains its current
momentum, there is definitely further scope for the oil price to go
up. There are additional price risks too: price increases for
industrial inputs, higher food prices, higher administrative prices
due to consolidation measures, improved production capacity
utilisation, possibly wage increases in some cases. Here we see a real
danger of the inflation rate remaining above the ECB target for longer
than anticipated. We expect the ECB to start raising interest rates in
summer.

Thanks to the ECB's relatively hawkish stance and the encouraging
signals from the bond markets, the euro managed to regain significant
ground this week. But the problems in the eurozone, particularly
investors' fears of sovereign default in the peripheral countries, are
still looming in the background. The package of measures planned to
overcome the financial crisis is a good sign; how effective it will be
remains to be seen. The negotiations over the restructuring of the
rescue fund are likely to cause much dispute, and the permanent
election campaign in the German Landtag could hinder unpopular
decisions. In our view, further upward potential for the euro is
limited.
Source: ActionForex.Com