The euro appreciated against the dollar as speculation that the European Central Bank is poised to raise borrowing costs outweighed concern that the fiscal crisis in the region's most indebted nations is deepening.

The euro slipped earlier today as Moody's Investors Service downgraded 30 Spanish banks, and tumbled late yesterday after Portugal's prime minister resigned. The ECB on March 3 said "strong vigilance" is warranted on inflation.

"The euro shrugs off these negatives because the market is focused on the ECB raising rates," said Jeremy Hale, London- based head of macro strategy at Citigroup. "It's expectations about rates that are driving everything."

The single currency was 0.2 percent stronger at $1.4120 at
9:46 a.m. in London, erasing a 0.3 percent drop. The euro is within two U.S. cents of its strongest level since Nov. 4. The currency appreciated 0.1 to 114.12 yen after declining 0.4 percent to 113.56 yen.

The ECB will announce its next monetary policy decision on April 7. Its refinancing rate is currently at a record low of 1 percent.

ECB council member Erkki Liikanen today said the bank's stance ensures that temporary inflation pressures don't fuel broader wage and price increases.

"Monetary policy ensures that inflation expectations remain firmly anchored and that broad-based inflationary pressures do not materialize," Liikanen, who heads the Bank of Finland, said in a statement accompanying the central bank's latest forecasts published in Helsinki today.

Eoin Treacy's view In a currency union where the interests of the members are not aligned, the question is how does one pitch monetary policy? The system that prevailed prior to the financial crisis where each country availed of Germany's low cost of credit without its fiscal discipline is gone. Efforts are underway to ensure that all member states compile statistics in a uniform manner and keep deficit spending within the mandated 3%. If successful this will create what David has termed DEM-lite. (Also see Comment of the Day on March 7th).


It is easy to forget that despite the expanded role the ECB has taken on, its core mandate is to keep inflationary expectations well anchored and core inflation below but close to 2%. Germany occupies a dominant role within the Eurozone and since it is also the equivalent of the pay master general for the currency union, what best suits Germany is likely to largely dictate how monetary policy is framed.

Germany's export oriented economy is prospering as global growth rebounds. The Euro's weakness, early last year, also offered a competitive edge to exporters. It is highly questionable whether the current low interest rate environment is appropriate for the German economy. With oil, metal and food prices all at uncomfortably high levels, inflation hawks at the ECB and Bundesbank will likely favour a mechanistic approach and vote for raising short-term interest rates.

In the USA, imbalances between one state and another are ironed out through worker mobility, a common language and a degree of Federal support for laggards. In Europe, worker mobility is limited, there is a plethora of languages and redistribution depends on the munificence of German taxpayers.

There is every chance that the measures agreed to by Eurozone governments in the next few months will create a sound foundation for the single currency. However the union's outstanding debt problems, which particularly plague Greece, Ireland and Portugal, remain a short to medium term unresolved issue. This Performance Filter of 40 sovereign CDS spreads illustrates the risk premium attached to these countries. Greece at close to 1000 basis points heads the list. Ireland is seen as on a par with Argentina and Portugal is in fourth position.

Incredible fiscal austerity measures have been imposed on these economies. Greece and Ireland are lobbying hard for a cut to the interest rate they will pay on bailout loans. Portugal's government has just fallen because it failed to pass the latest round of tightening measures. German voters are rebelling at the thought of committing additional funds without some concession on either further austerity, sales of state assets or corporate taxation. It is not at all clear that the peripheral countries concerned can deliver on these demands. In addition, the prospect of higher ECB short-term interest rates is not a welcome development for peripheral economies, whose growth remains on a fragile footing at best.

The results of new stress tests are due next week and the Irish banking system at least is expected to require an additional €20 billion capital injection. European banks, particularly in Germany, France and the UK hold a great deal of peripheral bank debt and remain susceptible to a restructuring which I view as a medium-term threat. The Euro is currently comparatively firm, particularly against the US Dollar and Yen. Investors appear to be concentrating on the potential for wider interest rate differentials rather than the cost of a Portuguese bailout or additional bank recapitalisations.

The DJ Stoxx 600 Banks Index has been largely rangebound for the last 18 months and is testing support at the lower side. The DJ Euro Stoxx Banks Index has steadied above 150 but needs to break the medium-term progression of lower rally highs to indicate a return to demand dominance beyond the short term.

The last year has been a rollercoaster for the Euro and its respective debt markets. I am reasonably confident that the region's challenges can eventually be surmounted but in the short-term I suspect a higher degree of volatility is a quite likely