Euro Strengthens on ECB Inflation Concerns

Highlights
* EU leaders planning to unveil comprehensive rescue package by end
of March
* Inflation outlook deteriorating
* Will Fed maintain extremely loose monetary policy?

!! Euro Strengthens On ECB Inflation Concerns !!
The euro has managed to hold on to and even extend last week's strong
gains. By mid-week, EUR-USD had actually risen over 1.35. Thus
negative sentiment towards the euro has continued to fade, even though
no substantial progress has been made in solving the problems in the
peripheral countries.

But the eurozone countries and EU institutions seem determined to
dispel financial markets' doubts over the eurozone rescue fund, and
this helped to calm the bond spread situation somewhat. Heads of state
and government are to decide on a comprehensive rescue package by the
end of March. The scope and volume of the EFSF are to be extended
significantly. One suggestion under consideration is that the EFSF
would be able to purchase troubled countries' sovereign bonds.

However, the main reason for the EUR-USD turnaround was the shift in
ECB rhetoric. Even though some council members have pointed out that
after Jean Claude Trichet's comments at the last press conference
interest rates will not be raised in the near future, the cat is now
out of the bag. Since last Thursday, money market rates have been
climbing continuously, and the market's interest rate hike
expectations have risen substantially. Given the prevailing turmoil in
the eurozone, market participants had apparently not expected the ECB
to react so sharply to rising inflation rates.

The ECB does not see risks to medium-term price stability at the
moment: it is expecting the inflation rate to drop below 2% again
towards the end of the year. But this forecast is rather uncertain, as
it remains to be seen how the year will progress. In the coming week,
the German inflation figures will give the first indication of how
much eurozone inflation will rise above the ECB target in January.
We are expecting the inflation rate in the eurozone to climb to 2.5%
in January, thus considerably overshooting the ECB target. The
inflation outlook for 2011 would then deteriorate significantly. The
ECB's interest rate hike rhetoric is thus likely to continue over the
coming months, particularly if growth remains strong. The ifo business
climate index went up again in January, and the French business
climate index has soared to within reach of record high pre-crisis
levels. This does not suggest that growth in the euro area will have
slowed down at the beginning of the year.

There has been a steady string of positive growth figures from the
other side of the Pond too. The regional purchasing manager indices in
the US turned out to be better than expected, indicating a sharp
acceleration in growth. Now Q4 growth is being estimated at around 4%.
Given that the leading indicators are constantly improving, the
outlook for the first quarter is not bad either. Thus markets will be
focused on the central bank meeting next week.

Although no-one is expecting the Fed to change its rhetoric, the
statement is bound to be closely scrutinised for any signs that the
Fed might be considering changing the timescale because of the
improved growth outlook. If the Fed leaves its extremely loose
monetary policy unchanged, the dollar is likely to remain under
pressure.
Source: ActionForex.Com