Higher interest rates and a stronger euro on their way in July

06/09/2011 3:31 pm EST


Jim Jubak

Founder and Editor, JubakPicks.com

Jean-Claude Trichet, head of the European Central Bank, spoke the magic words today: “Strong vigilance.”

The phrase has become the central bank’s reliable signal of a coming interest rate increase. The financial markets can now anticipate an interest rate increase, probably a 0.25 percentage point move, when the bank meets in July. The bank left its short-term benchmark interest rate at 1.25% today as expected.

Not too far down the road a resumption of interest rate increases from the European Central Bank—while the U.S. Federal Reserve remains on hold with the short-term U.S. benchmark rate stuck near 0%--will lead to a stronger euro against the dollar. (Higher euro interest rates will attract more buyers to euro denominated assets.)

Not too far down the road, but not today.

Today the euro is down slightly to $1.4519 as of 3:15 p.m. in New York as worries about German politics overshadow Trichet’s announcement. The German government of Angela Merkel and the European Central Bank remain at odds over a new rescue package that would finance Greece’s debt needs through 2014. Merkel’s own party is demanding that private investor be required to participate in any new package by agreeing at a minimum to roll over maturing debt. To the European Central Bank this still smacks of “restructuring.” The bank has said that any restructuring would trigger write downs of Greek debt that would prevent the bank from accepting Greek government debt as collateral from Greek banks. That would create a crisis for Greek banks.

Despite all the heat (and very little light) I think the two sides are edging toward some compromise. It’s hard to imagine that if push comes to shove German politicians would force Greece into default. I rather see a solution after German politicians have demonstrated to German voters, who remain deeply opposed to any further Greek bailout, that they have done all they could to make sure that bondholders share the burden.

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