Reality check for Europe

By Mike Dolan

LONDON, Feb 10 - (Reuters) - The extent of Europe's infection from the U.S. subprime mortgage virus is becoming clearer, even as the European Central Bank faces down calls for it to follow U.S. and UK counterparts by cutting interest rates.

Early estimates of fourth-quarter national output from the big euro zone economies are due later this week. The picture is probably one of growth in the 15-nation currency area marginally outstripping the U.S. economy in the final quarter of last year.

But there are growing signs the credit crisis and looming U.S. recession have hit Europe deeper than policymakers seem willing to acknowledge. Hopes that the euro zone can remain partly insulated from a U.S. housing bust and recession are receding.

Cisco Systems (CSCO.O), the largest maker of the routers and switches that direct traffic on data networks, warned last week of a rapid slowdown in both U.S. and European orders.

Significantly, the Cisco numbers suggested conditions were deteriorating faster in Europe than the United States. In the quarter through January order growth in Europe more than halved to 8 percent. U.S. order growth slipped only one percentage point to 12 percent.

"It's the most cautious I've seen CEOs in the U.S. and Europe in many years," Cisco Chief Executive John Chambers said.

That tallied with last week's shock service sector surveys. Any suggestion that Europe was weathering a U.S.-focused downturn seemed wide of the mark.

While attention largely centered on a plunge in confidence among U.S. service firms in January, German, Spanish and Italian service sectors also recorded their first contraction in years.

Financial markets are waking up also to the idea that it may be dangerous to use the relatively robust ECB economic forecasts as anything other than an interest rate pointer.

"The market is becoming aware that the crisis in the United States will indeed have an adverse impact on growth in Europe," said Heino Ruland, strategist at FrankfurtFinanz in Germany.

Pan-European stock markets have had one of their worst January performances on record and entered bear market territory in the course of that month. The FTSEurofirst .FTEU3 lost another four percent this week.

"We now see a deterioration in the euro area," said Luca Paolini, strategist at Credit Suisse. "If anything the risks are higher in the euro area than in the U.S. -- where expectations are already very low. And you still don't have a policy response from the ECB."

ECB President Jean-Claude Trichet acknowledged the darkening economic horizon after the bank left interest rates unchanged again at 4 percent on Thursday even as the Bank of England cut its key rates again by a quarter of a percentage point.

"If I take all the data, they confirm risks lie to the downside," Trichet told a news conference

Yet few expect an ECB rate cut for at least another month as the central bank focuses on above-target inflation rates instead. The combination of rising concern and a lack of action is worrying for many. The U.S. Federal Reserve has slashed its key interest rates by 2-1/4 percentage points in five months.