Euro Heads Back Towards Record High on German Economic Strength

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By Jennifer Yousfi
Managing Editor

An unexpected increase in German business confidence sent the euro to a one-month high versus the dollar yesterday (Wednesday) on speculation that the European Central Bank could be forced to hike interest rates to combat inflation.

Germany's Ifo Institute Business Climate Index increased to 103.5 in May from 102.4 in April. Economists had expected the index to decline to approximately 102.0.

"On the whole, the dampening of economic activity in Germany in the months following the very good first quarter should be moderate," the institute said of the results, which were gathered from the polling of 7,000 German firms, The Associated Press reported.

Germany is the largest economy in the European Union and has so far proved fairly resistant to the global credit crunch and the surge in dollar-denominated commodities. With the German economy helping to fuel Eurozone growth, the ECB can turn its attention to consumer price inflation. The possibility of an interest rate increase to help curtail soaring prices pushed the euro higher against the greenback.

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The euro traded as high as $1.5765 as of 1:22 p.m. yesterday in New York, Bloomberg News reported, a 0.8% increase from the day prior and headed towards the euro's all-time high of $1.6019, established April 22.

The ECB has remained hawkish on inflation, while the U.S. Federal Reserve, Fed Chairman Ben S. Bernanke and the central bank's policymaking Federal Open Market Committee (FOMC) have chosen to focus on the weak U.S. economy and pursued an aggressive rate cutting campaign to try to spur economic activity. The dollar has suffered as a result.

The minutes from the FOMC's April 29-30 meeting were released yesterday and indicated that the committee is still concerned by factors contributing to sluggish growth including the weak labor market, slowing consumer spending and continued lack of liquidity in the credit markets. Money Morning reported Monday that the Fed minutes were certain to be a key topic of conversation among economists this week.

The central bank committee that sets interest rates noted that "conditions across a number of financial markets were judged to have improved over the inter-meeting period, but financial markets remained fragile and strains in some markets had intensified."

The FOMC voted to reduce the Fed funds rate by 25 basis points at its April meeting, but due to the "improved" conditions, many believe the Fed will hold rates steady at the next policymaking meeting slated for June 24 – 25.

The signal of a Fed pause led to a brief rally in the dollar after the release FOMC's statement. However, a Fed that is holding rates steady is no match for an ECB that's raising rates.

"The euro is heading back to $1.60," Adam Boyton, a senior currency strategist at Deutsche Bank AG (DB) in New York told Bloomberg. "Interest-rate differential and high oil prices are supporting the euro."

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