Dollar remains on backfoot on subprime concerns

The euro got only a brief knock from a bigger than expected drop in German ZEW investor sentiment index for July. The current conditions indicator stayed strong and the data did little to dent expectation for a European Central Bank interest rate hike to 4.25 percent in coming months.

In the United States, in contrast, the consensus is for rates to remain on hold, with investors increasingly seeing a possibility that troubles in the U.S. subprime mortgage market could spill over into slower growth and prompt rate cuts.

“The ECB will hike so you will have a decreasing interest rate differential between the euro zone and the U.S. because the U.S. will still be on hold,” said Anders Soderberg, analyst at SEB Merchant Banking.

“The market has problems attracting dollar buyers... The mortgage market (concerns are) still weighing and people are wondering what the next step will be,” he added.

The ABX subprime index -- which is used by investors to hedge risks on mortgages for borrowers with poor credit histories -- fell on Monday, adding to pressure on the dollar.

The dollar index, which tracks the dollar’s value against a basket of six major currencies, has fallen for the past seven trading days, repeatedly setting 2-1/2 year lows.

By 1003 GMT the euro was steady at $1.3767 -- within sight of last week’s record high of $1.3813, according to Reuters data , but having pared earlier gains after the ZEW data was released.

The dollar was flat at 121.85 yen, while the euro was steady at 167.79 yen, after edging up to 168.17 -- near a record peak of 168.96 yen hit late last week.

The dollar set a 26-year low against sterling at $2.0446

after stronger than expected UK inflation data fuelled expectation of a further rate hike from the Bank of England.

The New Zealand dollar neared Monday’s 22-year post-float peak hit at $0.7940.

Soft dollar - but for how long?

On the data front, U.S. producer price figures due at 1230 GMT could help markets seeking to gauge latest thinking from the Federal Reserve on interest rates.

Capital flows data for May is also due at 1300 GMT.

However the releases are likely to take a back seat to U.S. consumer price inflation on Wednesday and to the twice yearly Congressional testimony on monetary policy by Federal Reserve Chairman Ben Bernanke.

Traders said any sign of concern by Bernanke about problems in the subprime market could prompt more dollar selling.

However others noted the speed of the dollar’s depreciation in recent weeks and said that overstretched positioning made the markets vulnerable to a correction.

“We moved neutral euro/dollar for the summer but fear a near-term correction this week,” Societe Generale said in a research note.

“Bernanke may well surprise the market with benign comments about the contagion risks from the sub-prime crisis, and hawkish comments about the persistent inflation risks.”