FOREX-Euro gains vs dollar in Q1, but debt fears persist

* ECB rate hike seen next week but future pace questioned

* Peripheral debt issues seen weighing on euro 2nd qtr

* EUR/USD 1-month implied vols down, but 1-year elevated
(Adds comments, updates prices, changes byline)

By Gertrude Chavez-Dreyfuss

NEW YORK, March 31 (Reuters) – The euro advanced in the
first quarter, boosted by expectations of euro zone rate hikes
following Thursday’s strong inflation numbers, but gains could
stall in the next few weeks due to nagging peripheral debt

Technical indicators suggested the euro was in the midst of
a correction to the downside against the dollar after gaining 6
percent in 27 days from the currency’s low of $1.3428 on Feb.
14 to last week’s high at $1.4249.

The $1.4249 level is the pair’s resistance, and if that
goes, euro bulls could target $1.4283, the Nov 4 peak.

On the way down, analysts said a strong break below the key
$1.4000 psychological level would signal a shift in the euro’s
uptrend, with downside support at $1.3850.

More importantly, the fundamental outlook for the euro zone
remains cloudy, particularly at the periphery, even though an
interest rate increase seemed imminent at a European Central
Bank monetary policy meeting next week.

“In our view, the euro will weaken on a longer-term horizon
… There’s an awful lot of (rate hikes) priced in at the
moment and that’s because of the change in language from ECB
President (Jean-Claude) Trichet,” said Frances Hudson,
investment director for strategy at Standard Life Investments
in Edinburgh.

Standard Life has assets under management of about $214
billion and the firm maintains a long dollar/short euro
position in its Global Absolute Return Strategy portfolio.

“If the ECB does hike, they would not hike massively. One
percent to 1.25 is not a big leap. After the first move, they
will wait and give it time and see what happens,” Hudson said.

The latest challenge to the euro zone was a bank stress
test in Ireland released on Thursday, which indicated that the
country’s banks need another 24 billion euros in capital to
plug potential losses. For more, click on [ID:nLDE72U2EF].

Analysts said the capital requirements would be tough to
meet and at some point the Irish government would have to
restructure the whole banking industry. This should weigh on
the euro as it begins the second quarter.

In early afternoon trading, the euro rose 0.5 percent to
$1.4194 (EUR=EBS: Quote, Profile, Research). It has gained more than 6 percent against
the dollar and 8.5 percent against the yen in the first
quarter, largely due to the outlook that the ECB would raise
rates well before the Federal Reserve and the Bank of Japan.
Asset returns in Q1 2011 graphic:
Key events in Q1 2011 timeline:

Stronger-than-expected euro zone inflation data on Thursday
reinforced forecasts of an ECB rate hike next week. For
details, see [ID:nLDE72U14W].

Futures markets see 125 basis points of ECB tightening over
the next 12 months from a record low 1.0 percent.

Against the yen, the euro (EURJPY=EBS: Quote, Profile, Research) was up 0.6 percent
at 117.75 after hitting a 10-month high at 117.90 yen.

In the options market, benchmark volatilities implied by
one-month at-the-money euro/dollar options (EUR1MO=: Quote, Profile, Research) fell to
9.3 percent on Thursday, a one-year low, suggesting euro zone
debt worries were not at the forefront for investors.

Six-month (EUR6MO=: Quote, Profile, Research) and one-year implied vols (EUR1YO=: Quote, Profile, Research)
remained elevated though, trading at 11.5 percent and 12.35
percent respectively.

Markets were also looking to Friday’s U.S. payrolls report,
which could likely dictate the euro’s direction against the
dollar in the near term.

Economists polled by Reuters have estimated 190,000 jobs
were added to non-farm payrolls in March after payrolls
expanded by 192,000 jobs in February.
(Additional reporting by Julie Haviv; Editing by Dan Grebler)

FOREX-Euro gains vs dollar in Q1, but debt fears persist