Euro strengthens on hawkish ECB talk

Market expectations for euro zone interest rate cuts are out of step with the inflation outlook, Axel Weber, European Central Bank Governing Council member said on Thursday.

Executive Board member Jose Manuel Gonzalez-Paramo also sounded a hawkish note on the prospects for rates and investors slightly pared back expectations on the extent to which they think euro zone rates will be cut.

"The euro is a bit stronger on the general tone after Weber's comments halted sentiment that ECB easing is coming quickly," said David Pais, currency strategist at Citigroup.

"The comments show that it will be hard for Trichet to marshal a consensus as there is a split emerging between more hawkish members of the ECB like Weber and those looking for a cut," Pais added, saying that Citi expects a cut late in the second quarter.

Meanwhile, expectations of US rate cuts were further bolstered by a pledge from Federal Reserve Chairman Ben Bernanke to act as needed to support economic growth and tackle downside risks.

"(Bernanke's) comments are likely to confirm the medium-term view that with its rate cuts, the Fed is doing the right thing in order to stem downside risks for the U.S. economy," Commerzbank economists said in a research note.

"However, by highlighting the downside risks to growth, Bernanke confirmed prevailing aggressive rate cut speculation, which currently keeps the dollar under broad pressure," the note added.

Also bruising the dollar was Moody's drastic ratings cut of FGIC's bond insurance arm on Thursday, making it the first big bond insurer to lose its top rating from all three major ratings agencies and keeping investors cautious about the struggling credit market.

By 8.22am GMT, the euro had touched $1.4665, its highest in a week. The dollar index fell as low as 76.038, its lowest in a week.

The dollar was up 0.3 per cent versus the yen at 108.25, but off a one-month high of 108.61 set the previous session.

Bernanke told the US Senate Banking Committee on Thursday that the central bank "will act in a timely manner as needed to support growth and to provide adequate insurance against downside risks."

His comments bolstered the view that the Fed will cut its benchmark rate by as much as 50 basis points when the US central bank holds its next policy meeting in March. It chopped 125 basis points from the federal funds rate last month, leaving the rate at 3 per cent.

The Bank of Japan left its policy rate target unchanged at 0.5 per cent as expected, with turbulence in financial markets and fears about a US recession heightening concerns over the economic outlook.

BoJ Governor Toshihiko Fukui said uncertainty over the world economy and in particular the US economy is rising.

Investors will look to US TICS flow data and industrial output data due later in the day for more clues on the outlook for the US economy. (Reuters)