By Natsuko Waki
LONDON, Feb 15 (Reuters) - The euro is set to grab the limelight this week as economic data deteriorates, more signs of trouble emerge in the region's banking sector and turmoil in Eastern Europe threatens to spill over.
Already one of the worst performing currencies this year, the euro will face a further stress test this week when more banks and corporates report their earnings in a region where some analysts estimate earnings lag the U.S. cycle by up to four quarters.
The vulnerabilities of eastern Europe, where euro zone banks are hugely exposed, are also starting to add to pressure on the common currency, which has lost around 6-8 percent against the dollar, yen and sterling this year.
Moreover, the European Central Bank kept interest rates this month at two percent, the highest in the Group of Seven economies -- leaving scope for speculation that this yield premium will disappear, but only after a delay that intensifies the economic downturn.
"The euro looks vulnerable given the unfavourable backdrop of plummeting economic activity, increasing fiscal problems, worries about the health of the banking system and a tardy central bank," said Ken Wattret, chief euro zone market economist at BNP Paribas.
"What concerns me for the euro area is that the adjustment in the economy is just beginning. The exposure of euro area banks to Central Europe is clearly comparatively high through its geographical proximity and that's a greater concern for the euro zone (than elsewhere)."
On Friday, data showed that the euro zone economy underwent its deepest contraction on record in the fourth quarter of 2008, which boosted expectations that the European Central Bank would cut interest rates next month.
The euro was trading at around $1.2880 on Friday, not far from the 2009 low of $1.2704 hit earlier this month.
LAGGING EFFECT Last week, Ireland's efforts to bolster its banking sector hit the bumps as a deposits scandal at Anglo Irish Bank overshadowed the government's move to beef up its bank rescue package for the country's main lenders Allied Irish Banks and Bank of Ireland.
L'Oreal, Commerzbank, Aegon, Societe Generale and BNP Paribas are some of the companies which report their quarterly earnings this week. Credit Suisse forecasts profits in non-financial European firms to fall about 35 percent this year, while it expects a 25 percent decline in U.S. non-financial profits.
The Swiss bank's earnings outlook for Continental Europe is worse than for the United States partly because it thinks European monetary conditions are still not loose enough.
Within sectors, Credit Suisse thinks autos, semiconductors and tech hardware rank best while tobacco, pharmaceuticals, food products and healthcare equipment are most vulnerable.
The European Central Bank's reluctance to cut interest rates aggressively has caused the euro to sell off and Goldman Sachs also recommends investors bet on lower inflation in the euro zone than the market is currently pricing in.
According to Goldman, the average inflation rate in 2011-2012 implied by the inflation swap market has shifted since December to 1.6 percent from 1.0 percent for the United States and 2.4 percent from 1.0 percent for the euro zone.
"In cross-country inflation strategy ... we think short-to-intermediate inflation swaps have risen far too aggressively in Euroland relative to the U.S.," Goldman said in a note to clients.
"Euro zone monetary policy is still confined to conventional easing -- which is largely ineffective given how severely impaired is the broad credit market -- and fiscal policy in the euro area is also lagging behind, and is largely perceived as reactive rather than proactive."
Goldman recommends selling euro zone five-year inflation swaps against the U.S. counterpart.
NEIGHBOURING WOES
The wave of turmoil in emerging Europe could reach the shores of European markets soon, given the strong link between banks.
Data from the Bank for International Settlements shows Eastern European banks had accumulated total external liabilities to BIS-reporting banks of $1.657 trillion as of September 2008, of which $1.511 trillion is owed to European banks. In the period between 2005 and 2008, European bank exposure tripled.
Brown Brothers Harriman says countries with high emerging market exposure relative to gross domestic product include Austria (82 percent), Switzerland (53 percent), the Netherlands (49 percent) and Belgium (42 percent).
"They have the sum of all sins," said Tim Ash, head of emerging Europe research at Royal Bank of Scotland.
"European banks are clearly heavily exposed to emerging Europe via a rapid accumulation in assets in the region. As the region slows down rapidly, asset quality is likely to deteriorate quite significantly."
Merrill Lynch says the current account deficits of Bulgaria, Estonia, Latvia and Lithuania -- whose currencies are all pegged against the euro -- are at 15-24 percent of GDP, levels that have historically been associated with currency crises.
Bulgaria, Hungary, Latvia, Lithuania, Estonia, Romania, Russia, Ukraine and Kazakhstan have already had their credit ratings cut in the past six months -- a factor which has pushed the euro lower in recent weeks. Ratings agency Moody's put Estonia and Lithuania on notice for possible ratings downgrades last week.
(Editing by Ruth Pitchford)