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Euro Shoots Up After ECB Rate Hike

But there's more to the euro's strong advance than meets the eye.

The big surprise last week was the

European Central Bank's

decision to hike key interest rates 25 basis points. Prior to the announcement, surveys found that only one in four observers thought such a move was likely. The euro enjoyed a strong advance after the rate hike, shooting up 2 cents against the dollar, recovering nearly all the ground lost over several previous sessions.

There is more to this than meets the eye, however. In and of itself the rate hike means little: The normal volatility of the foreign-exchange market is sufficient to overwhelm a 25-basis-point change in the annualized interest-rate differential. To the extent that the rate hike is significant, its importance lies in the way it signals policymakers' concerns.

A careful examination of the price action after the ECB announcement reveals that the euro did not really rally until after ECB President

Wim Duisenberg's

comments. Those comments were the clearest expression of concern about the weakness of the euro, with Duisenberg indicating that the currency's weakness was an important, although not decisive, factor behind the decision to raise rates.

It's useful to think of intervention as an escalation ladder. The first rungs are expressions of concern and moral suasion, then come threats of intervention, actual intervention, and coordinated intervention. Until last Thursday, European officials had not even put a foot on the ladder. Their general attitude was that the euro's weakness was temporary and that the currency would strengthen in the medium term. Some may have even welcomed the currency's weakness as a way to promote exports, a bright spot in several countries, including Germany, the largest economy in the region.

The fact that the ECB was finally stepping onto the ladder prompted short-term traders to buy their previously sold euro positions. What turned the short squeeze into a rout, however, was far removed from what policymakers said or did. News that


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had finally been accepted led to strong buying of the euro for British pounds. That appeared to fuel the euro's strong rise. Even though it is an all-stock deal, market observers suggest that the transaction could still require Vodafone to purchase as much as 5 billion euros ($4.95 billion) with cash. Arbitrageurs shifting money between U.K. and German shares may also have scrambled to buy euros.

The rally lifted the euro to a key chart point near $0.9950, which corresponds to a


38.2% retracement of this year's slide. Technical analysts use these chart points as mileposts for tracking a currency's rise or fall. The euro pulled back after unexpectedly weak German manufacturing order data -- which raised concern that the ECB hike may have been premature -- and stronger-than-expected U.S. employment data. The move signals the end of this part of the correction. A significant, sustained break below $0.9775 would likely wash out some of the longs established in the melee on Thursday and signal a likely retest on the historic low set near $0.9665 at the very end of January.

Our preferred scenario is that the euro bottoms near there, but obviously the risk that it moves even lower has increased over the past couple of weeks. A break of, say, $0.9500, could quickly send it toward the $0.9100 to $0.9200 area. More disappointingly, weak European data will weigh on the euro in a way that encouraging data have not helped it. Market sentiment has not really turned, despite the currency's dramatic one-day bounce. Contrary to what classical economics says about a lower price encouraging demand, I suspect there will be better demand for the euro if it can rise above the $1.00 to 1.01 area. In addition, if the new Vodafone-Mannesmann enterprise has to sell some parts, as some observers have suggested, this could lead to outflows from the euro.

Some pundits have suggested that with this merger a rash of foreign direct investment into the eurozone is likely. While I agree that this is coming, it's not likely that it will be driven by the Vodafone-Mannesmann deal. The issue of hostile takeovers was not really addressed, so much as sidestepped. Moreover, some observers seem to exaggerate how much resistance to hostile takeovers discouraged direct investment in the first place. A whole host of factors gets taken into account when a corporation decides to make a direct foreign investment, and the specific type of acquisition is a relatively minor consideration.

Marc Chandler is the chief currency strategist for Mellon Bank. At the time of publication, he held no positions in the currencies or instruments discussed in this column, although holdings can change at any time. While he cannot provide investment advice or recommendations, he invites you to comment on his column at