Last Thursday, the president of the European Central Bank (ECB) Jean-Claude Trichet vowed “strong vigilance” over inflation and said an interest rate hike is possible at the next policy rate meeting.

His comments immediately sparked a rally in the euro against the dollar. 

The rally extended as high as 185 pips, or about 1.34 percent. Now, on Tuesday morning New York time, the gain has been cut to about 30 pips,

The main reason is that the European debt crisis is back in focus.

Yields on Portugal’s government debt have been steadily rising for some time (10-year yields are above 7 percent). Now, the market may have finally taken notice of Portugal and other peripheral countries’ continued deterioration.

Several recent factors may also be exacerbating the problem.

One, when Trichet was spewing his hawkish rhetoric – and the market happily bought the euro – investors seemed to forget that raising rates would push up the borrowing costs for the struggling peripheral European countries.

After all, the borrowing cost consists of the ECB’s benchmark rate plus the country-specific spreads.

High borrowing costs for peripheral countries, of course, was the problem in the first place.

During the height of the EU debt crisis, analysts pointed out that the ECB couldn’t afford to raise rates precisely for that reason.   

This logic still holds true today, although it may have been ignored by the market recently.

Two, European Union (EU) leaders have given little indication that they will do anything substantial to fix the peripheral debt problem.  Of course, if a full-blown crisis hits Portugal, they may be spurred into action.

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