In the short term, market participants tend to have a very narrow focus when it comes to determining what information influences their decision making. And were certainly seeing that now
I say that because despite all of the underlying problems in the world, the dominant focus in markets for the past few weeks has been all about the interest rate outlook.
The big question: Which major central bank will be the first to move rates off of historic lows and start an interest rate hiking cycle?
At first the U.S. was in the pole position. But after the economy began sputtering around the middle of last year, that notion was put to bed. In fact, the Fed rolled out MORE accommodation another dose of QE.
Now the focus is on euro-zone rates and the European Central Bank (ECB).
But how, you might ask, can Europe even consider raising interest rates when many euro-zone economies are on life support?
Under the current ultra-easy monetary policy in the euro zone, Greece required rescuing, so did Ireland. Neither can borrow at current market interest rates to keep their countries solvent. Portugal will likely join that group in the coming weeks. And Spain looks like a strong candidate too.
Why Would the ECB Risk Exacerbating That Problem by Raising Rates?
Simply put, because it has tunnel vision on just one thing: Inflation.
In the U.S. things work a bit differently
The Fed determines its monetary policy based on several factors. Employment and inflation are the main two. Plus it looks at things such as the output gap and general economic stability. Given all these factors, the Fed will likely hold the line on its ultra easy monetary policy for quite a while longer.
But in Europe, its all about inflation. So as long as the inflation data peeks above the ECBs target level, history shows that rate hikes will follow.
Just go back to 2008
While other central banks around the world were aggressively slashing prices as the global financial crisis was unraveling, the ECB was in action too not slashing rates, but pushing them even higher!
Many called this move a big mistake. And they fear another mistake is coming.
Take a look at the chart below. It shows a +2.4 percent recent reading for the central banks favored measure of inflation above their 2 percent target zone (the blue line).
Given what this chart shows, the ECB has played right into the rate hike speculation. ECB president Jean-Claude Trichet and other policymakers have been talking up their concerns about inflation and setting expectations for a move as early as next month.
As you might imagine this has a big ramification for the euro.
After all, in normal times, interest rates play a huge role in currency valuation. A currency with rising interest rates tends to attract capital. And strong capital flows tend lead to a strong currency.
But these arent normal times.
Will Higher Rates Be a Boon or a Bust for the Euro?
In 2008, when the ECB hiked rates one last time as shown in the following chart, it triggered anexodus from the euro. In fact, it marked the all-time high in the euro. And then it fell 23 percent against the dollar over the following four months.
This gives plenty of reasons to keep a close eye on the euro.
Like in 2008, Europe is now facing a host of problems. The PIGS countries are in trouble. And European officials still dont have a solution. Their attempt to return government bond markets back to normal hasnt worked.
The cost of borrowing for the weak euro-zone countries remains at unaffordable levels and has been rising steadily with the prospects of an ECB rate hike. And the downgrades keep coming
This week Greece and Spain were downgraded. And Portugal is on downgrade watch.
Given that backdrop, a decision by the ECB to move rates higher would likely mean bigger problems for the sovereign debt crisis. And that means big problems for the euro.
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