Euro Likely To Suffer One Way Or Another

The euro zone may well prove immune to the subprime mortgage woes sweeping through the U.S. economy. But that doesn't mean that, as a high-yielder, the euro won't still suffer from rising global risk aversion.

Much, of course, will depend on whether the European Central Bank feels it can afford to hike interest rates again next week. Increasingly, though, it looks like fears of a credit crunch will be the deciding factor. "Financial market conditions rather than the macro data will determine the fate of the ECB's rate decision next week," said Martin van Vliet, senior euro-zone economist at ING Financial Markets in Amsterdam. ECB President Jean-Claude Trichet hinted as much when he took an important step back from the bank's previous hawkish stance earlier this week, admitting to reporters after a speech in Budapest Monday that the bank is not "precommitted" to higher rates at its next meeting Sept. 6. Only last week, the ECB was declaring that its underlying policy remained unchanged despite the recent need to add liquidity to European markets, as a rise in risk aversion brought a sharp deterioration in global credit conditions. Trichet's apparent shift in position has coincided with data suggesting that while the U.S. economy is looking increasingly vulnerable to subprime problems, the euro zone isn't. Take the Ifo survey of German business sentiment that was released Tuesday - instead of falling back to 105.2 as expected in August, the main sentiment index only fell to 105.8 from 106.4 in July.

Euro's Weakness Widely Expected

Given the recent rise in euro-zone interest rates, the strength of the euro and the weakness in U.S. growth, the deterioration in sentiment had been widely expected. What was surprising, however, was that the volatile conditions of global financial markets in recent weeks didn't have more impact. If anything, sentiment could improve from here. "Comments from the Ifo Institute suggested that the dip in expectations was normal and that with overall growth still robust economic sentiment could improve next month," noted Stuart Bennett, a currency strategist at Calyon Credit Agricole in London. The Ifo has "defied market turmoil," said Erik Sonntag, ING's German economist in Brussels. "An impact on the real economy cannot be detected so far." For the ECB, new money supply data only added to the impression that inflation remains a risk for the euro zone. The three-month average measure of the region's M3 money supply surged to a two-year high of 11.1% in July from 10.6% in June. The market had expected growth to accelerate to only 10.9% on the year. "With money and credit growth remaining in double digits, the ECB will stay seriously concerned about the medium to long-term inflation outlook for the euro zone," ING's van Vliet admitted. Nevertheless, many analysts remain convinced that the ECB will take its cue from global trading conditions that a credit crunch may yet develop, even though there is little sign of fallout in the euro zone economy just yet. "Given Trichet's comments effectively flagging that the bank is in a 'wait and see' mode and will delay the previously expected rate hike on Sept. 6, the data are unlikely to have an impact on policy," said Calyon's Bennett, as he noted the fears a financial crisis could imply fewer funds being made available to firms in the months ahead. Stephen Jen, senior currency strategist with Morgan Stanley in London, suggested that Trichet's comments are consistent with the view that there is a slightly better than 50/50 chance of a rate hike next month. Also, he added, it probably means the end of the ECB's recent policy of giving heavy forward guidance to the market of its rate views as the outlook for the global economy turns more uncertain.