The euro has decoupled from the euro zone peripheral debt crisis in 2011.
While the spreads on credit default swaps on Portugal, Greece, and Ireland sovereign debt have widened and hit new highs, the euro was the best performing G10 currency in the first quarter of 2011.
The reason is that Spain, the weakest link in the euro zone that has not been bailed out yet, appears to be fine.
Currently, the bailout mechanism of the European Union (EU) has enough funds to save Portugal, Greece, and Ireland. The real worry was Spain, whose economy is the fourth largest in the euro zone and dwarfs the combined size of Portugal, Greece, and Ireland.
The Royal Bank of Scotland chart below shows that in contrast to Portugal, Greece, and Ireland, the spread on Spain’s credit default swaps have actually fallen in 2011.
The International Monetary Fund (IMF) and other experts attriibute Spain’s reform efforts in the pension system and banking sector for gaining confidence with investors and thus avoiding the need for a bailout. (Portugal arguably wouldn’t have needed a bailout either if the country had accepted a self-imposed austerity package.)
Meanwhile, inflation in the euro zone is pushing past the target pace of 2 percent per year.
The incentive for the European Central Bank (ECB), therefore, is to raise interest rates. The euro, largely free from Spanish debt worries and benefiting from interest rate expectations, has therefore performed well in 2011.
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