- The ECB tests the waters?

- The return (yet again) of risk aversion

- US worries grow

The currency market sensitivity to global economic risk was graphically demonstrated by the reaction to comments by Yves Mersch, European Central Bank (ECB) board member and head of the Central Bank of Luxembourg. He was quoted on Wednesday saying that risks to economic growth in Europe have increased, that the ECB can look through the temporary inflation jump, that the ECB should be cautious given the economic uncertainty and that there are factors that mitigate inflation risks.

From the market response you would think no one from the ECB had ever voiced such opinions before. In fact Jean Claude Trichet, the bank president, referred to an inflation bump several weeks ago to no discernable interest. But Wednesday was a different day and traders took Mr. Mersch’s comments to heart sending the yen crosses and euro cascading down through a series of stop runs that lasted more than an hour. The euro, the euro/yen and the gbp/yen each lost more than two figures before recovering. This was in marked contrast to the market reaction to the strongly anti inflation remarks of Jurgen Stark and Alex Weber, also ECB board members, earlier, which had spurred little if any movement to the upside in the euro or the yen crosses. Mr. Weber had said that the bank will counter resolutely inflation expectations consolidating above the 2.0% target.

The difference between the two market responses is the perceived state of the US economy and the probable effect of its slowing on the rest of the world. When Mr. Trichet made his comment a US slowdown was feared but not supported in statistics. We have since had a dismal Non Farm Payrolls and negative December Retail Sales. The US slowdown looks much more real than it did in December. And Mr. Mersch seemed to verify what many traders now suspect, if the US economy heads south, the Europeans will soon follow. But what really exercised traders’ interest, and why the relatively unknown Mr. Mersch touched off such a slide is the notion that the ECB board may be coming around to the same opinion and that Mr. Mersch was giving its first airing.

When the market hears something that confirms its view it acts and when it hears something that contradicts its opinion it often ignores the information. Until recently traders had punished the dollar for weak US statistics. American figures were very poor this week, much worse than expected and the dollar closed Friday on its high against the euro, more than 300 points below its immediate post Retails Sales peak on Tuesday.

What drove the market lower was stop loss selling in the euro and the yen crosses. But what are stops but market judgment on risk? The risk now lies to the downside for these currencies and conversely on the upside for the US dollar. It is not of great importance that the change in risk perception is generated by an increasingly negative outlook for European growth and the consequently increased chance for an ECB rate cut rather than positive news from the US economy. What is important is that a European slowdown and a potential ECB reduction, and even a possible global slowdown, are not priced into the current euro/usd levels and certainly are not part of the yen crosses. All three eventualities, a European slowdown, an ECB rate cut and more negative US news are more likely than they were two weeks ago. The first two are barely priced. Adjustment to the new reality in the euro and the yen crosses has just begun..