All eyes on the euro and interest rates

Ground Floor/Sheila O'Flanagan: It's summertime and soccertime and the markets may be unexpectedly volatile but you can be sure that there will still be more bets made on the outcomes of Euro 2004 matches than on the direction of interest rates for the next couple of weeks - even if interest rates have been the hot topic of discussion on trading desks lately.

It has always been the case that dealers enjoy betting on any sporting contest and so economic stories that would normally be chewed over in minute detail will take a back seat to in-depth analysis of the disaster that was Portugal's opening match and the 90th minute trauma for Inger-land.

I bet it's not just the team that are feeling savaged, it's also the punters who'd backed Sven's men and thought that they'd beaten the odds just for once!

The Portuguese, of course, are taking an economic as well as sporting view of the soccer since an estimated half a million people have made the trip to the championship.

The Portuguese economy contracted last year and the general hope is that high-spending football tourists will make a big difference this year.

The construction industry has already benefited, of course, with all of the building work ahead of the tournament itself bringing much needed employment and income into the region.

Now local businesses are hoping to reap the rewards from the travelling fans and part them from as many euros as possible.

Tourism, of course, has always been a major earner for the Portuguese, accounting for about 10 per cent of GDP, but it still lags behind neighbour Spain as a hotspot destination. Euro 2004 gives it an opportunity to redress the balance somewhat.

UEFA expects revenue from the soccer tournament to more than triple from the last event and estimates that around €260 million will flow into the economy as a result.

The tourism sector is hoping that a positive experience this summer will mean that many of the fans will come back when the dust has settled and prices are lower again - like everyone, it needs to fight back against the lure of still cheaper holidays in Eastern Europe.

However exciting the soccer may prove to be, though, the US interest rate situation is the key economic issue in the weeks ahead.

Forex traders saw the dollar track its biggest weekly rise against the euro in five months last week.

That's because another couple of Fed presidents talked up the likelihood of further rate hikes in the US.

The consensus now is that rate rises may come faster than previously expected.

William Poole, the president of the St Louis Fed, commented that the bank was prepared to raise rates "further and faster" if necessary while Federal Reserve chairman Alan Greenspan himself has reminded traders that the Fed is ready to do "what is required".

The reason for all this is that inflation pressures are bubbling in the US economy - import prices rose by 1.6 per cent in May which is twice what most analysts had predicted. April prices were up 0.2 per cent.

Even if consumer price index numbers come in lower than expectations for any month in the near future, the underlying inflationary trend is upwards and that's what has the Fed concerned.

Obviously the recent oil price hikes have added considerably to inflationary pressures and the priority task for the Fed is to decide how long-term the impact of those prices rises will be.

Officials believe that the financial markets - while lagging behind their estimates of rate hikes - are still in a better position to deal with potential increases than 10 years ago when the last aggressive tightening cycle began.

At that time, the Fed raised rates by 300 basis points in the space of a year.

The key word which outlines the shift in Fed policy now is its plan to be "'measured" with rate hikes rather than "patient".

And you thought that such nuances only existed in the Leaving Cert English exams!

The reaction of traders has been to sell off treasuries. The 10-year US benchmark bond is now yielding around 4.8 per cent from its lows in March of 3.65 per cent.

The most recent 10-year auction, where the Treasury managed to sell $10 billion of bonds, was one of the strongest in the last 10 years and yielded 4.828 per cent.

But traders are suggesting that it will trade in a range about 4.7-5.15 per cent until the Fed's next meeting at the end of the month, in which case the treasury will have got a bargain.

And if rate hikes continue, the yield will look more and more attractive from the Fed's point of view and pretty grim from that of the bondholder.

The Merrill Lynch's treasury index is down a whopping 4.2 per cent this quarter which is the worst quarterly performance since 1980 so traders may have their work cut out to turn a profit on their recent purchases. The likelihood is that many of the buyers were overseas investors, seduced by the yield and the prospect of a stronger dollar in the future and prepared to invest some funds now while possibly holding back more for later when they would hope to see even higher yields.

Certainly there are a number of people who believe that we can revisit the 300 basis point increases. Payroll numbers are pointing to an end to the jobless nature of the recovery as employment levels are rising again. But too rapid an increase could have the same effect as it had 10 years ago and cause any recovery to stall.

From the Fed's perspective, however, labour costs are now rising faster than productivity. Back in 1994 unemployment was around 6.5 per cent. It's currently 5.6 per cent which would underpin any tightening tendencies the authorities may have.

A change in Fed strategy now would mean an end to the euro's flirtation with strength against the dollar. Just like the English team, it's put in a lot of hard graft but it could lose out in the end.