Euro looks to be on slow upward trajectory

The euro appears to have rebounded, although only time will tell for sure if this a real turning point or just another blip on the way down. Certainly the European Central Bank is talking it up and president Mr Wim Duisenberg is hoping that it will appreciate further.

And well he might. Despite this turning point, the currency has lost almost a quarter of its value against the dollar and there are many who are hoping that it will not be long before it manages to return at least to parity with the US currency.

As it stands, such a target seems reasonable. The euro's recovery is based on a number of factors including the recoveries of the euro-zone economies, the slackening off in demand in the US and a new willingness of ECB chiefs to agree with one another.

All three are probably sustainable over the longer term. There has been a good deal of good news coming out of many of the euro-zone states over the past months. Germany's first-quarter gross domestic product rose by 3.3 per cent; in France, business confidence is high. Unemployment is falling in both.

Of course, some of this is the result of a weak euro and for that reason institutions such as the Bundesbank may not want to see too rapid an improvement.

In the US, there is growing evidence of a downturn. Employment figures have been reassuringly weak for the past two months as have retail sales and housing starts. Growth in the first quarter was 5.4 per cent and, according to Mr Jim Power, chief economist at Bank of Ireland, this is likely to slow to 4.5 per cent in the second quarter. The prospective figure for the third quarter is still the subject of much debate but Mr Power feels it may come in around 3.5 per cent.

If this were to happen, it would probably be good news for the Federal Reserve which has been trying to engineer a soft landing for some time. Such a slowdown would affect demand.

The Economist produced an interesting graph from UBS Warburg this week, which showed the relationship between the level of the euro and the underlying currencies, to the gap in the growth of domestic demand between the euro zone and the US.

The correlation is striking and, if history repeats itself, the slowdown in demand in the US and its increase in the euro zone should lead to a rebound in the euro.

But it is also important to remember that the slowdown in US growth is from an incredibly strong base of more than 5 per cent. That could mean that any slowdown would not lead to a cut in US interest rates over the next year.

If that were the case, there would still be a significant differential between US rates at 6.5 per cent and euro rates which seem headed for 5 per cent. That is likely to put a floor under the dollar and prevent very significant euro appreciation.

One problem that the Fed could have with this view of an imminent soft landing is if the equity markets were to take off again. Over the past month the Nasdaq is a little higher, following large reversals, and the Dow is broadly unchanged.

According to Mr Power, an equity surge could happen if markets came to the view conclusively that interest rates were not going up again. With the positive impact of the wealth affect, as investors started to spend again, markets and the dollar could rise.

But this does seem unlikely. There is evidence already that lending terms and conditions are being tightened and two banks have issued warnings about bad debts. Both Wachovia Bank a conservative bank in north Carolina and Union Bancal have warned that problem loans are on the rise.

The other possibility is that the downturn turns into a sharp slowdown and a hard landing, forcing a crisis of confidence in financial markets. This would result in Japanese and other investors withdrawing from the market, throwing the balance of payments into sharp relief as the money would simply not be there to fund it.

That would have a very significant downward impact on the dollar.

But if the economy just slowed gently as seems likely and the ECB executives, Commission officials and others managed to go on restraining themselves, the euro might be on a slow but gentle upward trajectory. That is one piece of news that would be welcome for Irish inflation.