The euro drifted higher after a stronger-than-expected manufacturing sector performance in the 12-nation area highlighted the need for increases in interest rates.
In data just out, it was revealed the euro zone's manufacturing expanded at its fastest pace in five and a half years during March. The manufacturing sector purchasing managers' index rose to a seasonally adjusted 56.1 from February's unrevised 54.5, sources said.
Analysts had penciled in a more modest rise to 55.0.
West LB analysts described the increase as " further indication that economic recovery is proceeding well".
Given the relentless flow of strong economic data out of the area, the European Central Bank is predicted to start preparing the market for another rate hike in May. The central bank delivers a rate decision this Thursday, but no change is expected just yet. The ECB has hiked rates by two quarter-points since December, taking the benchmark refi rate to 2.50 pct from 2.00 pct. Mitul Kotecha at CALYON believes the trend of strong economic data will to continue this week and may well lead to a hawkish tone from the ECB's post-rate verdict news conference this week.
"The strength of recent money supply growth and credit growth, especially the double digit growth in loans to purchase homes, could see a more hawkish tone, which could support expectations of a May rate hike rather than June," he added.
"A combination of strong data and hawkish ECB rhetoric will maintain the pressure on interest rate markets and we continue to expect interest rate futures to move towards pricing in euro zone rates at 3.50 pct in first quarter 2007," said Kotecha. The pound, meanwhile, edged lower after the UK equivalent of the manufacturing PMI disappointed. The manufacturing sector purchasing managers' index from the Chartered Institute of Purchasing and Supply fell to 50.8 in March from a downwardly revised 51.5 in February. The latest reading is the lowest since August 2005.
"Coming on the heels of much better than expected manufacturing numbers from Germany and France, this shortfall in March is particularly noteworthy and will pile more downward pressure on the pound, which was already on the retreat ahead of the release," said Daragh Maher at CALYON.