EUR Rebound is Fundamentally Suspect

Highlights
* EUR rebound is fundamentally suspect
* Has Europe's sovereign crisis turned a corner?
* Fears of aggressive China tightening may unwind soon
* A chilly fourth quarter for the UK
* Precious Metals may enter Q1 2011 predicted "Buy zones" next week
* Key data and events to watch next week

*EUR rebound is fundamentally suspect*
The EUR finished out the past week at two month highs against the USD
and posted strong rebounds on the crosses as well. The EUR recovered
even after EU finance ministers failed to deliver a concrete long-term
debt resolution mechanism (see more below), postponing a likely plan
to late March. While there has been some movement on the part of
Germany to show greater willingness to provide assistance to the
periphery, the German government remains insistent that other EU
countries will need to shoulder more of the cost as well. This raises
the question of how highly indebted countries like Belgium, Italy and
Spain will be able to come up with their shares of any support
package, and this is the source of our skepticism on the
sustainability of the EUR recovery. German data has continued to
surprise to the upside with ZEW and IFO surveys all pointing to
further strength in the core, and this has also provided the Euro with
support.

But core Eurozone strength was never really the issue, but rather how
the periphery will muddle through. On that count we still have serious
doubts that major debt restructurings (i.e. defaults) can be avoided
in several of the peripheral nations. In that sense, we view the
recent unwinding of bearish EU bets (e.g. short EUR, long sovereign
CDS, short peripheral bonds) as a temporary position adjustment,
rather than the end to the European debt crisis. Similarly, we think
the fears of an ECB tightening phase are overblown and that even
ueber-hawk and potential next ECB president Axel Weber this week
downplayed the risks from inflation and called current policy
appropriate. We prefer to use current EUR strength as an opportunity
to establish more fundamental short EUR positions for an expected
decline in the weeks ahead (see the Weekly Strategy).

*Has Europe's sovereign crisis turned a corner?*
This time last week the market was looking forward to Eurozone
officials taking decisive steps towards creating a permanent solution
to the sovereign debt crisis. However, two meetings of EU officials
passed with no resolutions agreed. In fact, the German Finance
Minister Wolfgang Schaeuble said that the calm that has descended on
the peripheral bond markets in recent weeks meant there was less
urgency to make changes to the current European Financial Stability
Facility (EFSF).

It seems likely that there will be no progress on a permanent solution
until the EU council meeting scheduled for 24-25 March. Then officials
may agree to an extension of the EFSF fund, which currently stands at
EUR440bn. The timing of this meeting is important since it comes just
before a state election in Germany on 27 March. Only after this can
the German Parliament debate proposals for a permanent bailout
facility.

Even though it may seem like Europe's debt problems have been pushed
down the road, the market has given Europe the benefit of the doubt.
The euro has extended its rally this week and looks fairly comfortable
above 1.3500. Investment flows into the safety of German bunds has
also fallen, which has pushed up bond yields. The spread between
German and US 2-year government debt has widened to its highest level
since November 2009, which could fuel EURUSD gains back up to 1.4000.
The single currency may have yield on its side, but the path to 1.4000
could be bumpy. There has been a shift in the discussion of Europe's
sovereign debt crisis away from bailouts and towards default in
Greece's case and bank sector nationalization in Spain.

Reports that Germany was working on a plan to provide Greece with a
loan to buy back its bonds in a restructuring that could apply
haircuts to senior bond holders was swiftly denied. If this is true,
it would suggest that the EU is taking the first steps towards fiscal
unity, which flaunts the fiscal sovereignty rule in the European
constitution. However, officials may not be willing to take such
drastic action yet, even if it does sound like a sensible long-term
solution to Greece's problems. The cost to insure Greek debt for five
years has fallen this week, suggesting that restructuring could bring
some certainty to investors and actually reduce risk for investors
holding Greek debt. If you know for certain that you could be subject
to a haircut then you can price Greek debt accordingly.

Spain meanwhile is working on recapitalizing its troubled Caja banks.
The financial position of the 17 domestic lenders is precarious at
best. They are scheduled to report all of their non-performing loans
and property holdings by 31 January. This could cause market jitters,
especially if their liabilities are larger than the approximately
EUR50bn the market is expecting.

*Fears of aggressive China tightening may unwind soon*
China's pace of economic growth accelerated above expectations (Q4
Real GDP y/y printed +9.8% vs. expected +9.4% in Dec.) which was also
reciprocated in Dec. Industrial Production (+13.5% y/y vs. expected
+13.4%) and Dec. Retail Sales (+19.1% vs. expected +18.7%). The
markets' reaction to positive China data surprises, however, was
negative. Fears of a potential ramp up in PBOC tightening measures
gripped financial markets with the brunt of the impact hitting
commodities - gold declined -1.7%, WTI crude oil fell -2%, and silver
lost around -4% post data release. Commodity currencies experienced
concurrent declines as AUD/USD fell sharply below parity to lows
around 0.9835 and USD/CAD soared to highs around 1.0030. However, the
commodity market selloff should be taken with a grain of salt as
speculation for more aggressive PBOC rate hikes are likely to be just
that - speculation. Steadying inflation - December consumer prices y/y
declined to 4.6% from a prior 5.1% as did producer prices to 5.9 %
from a prior 6.1% - may balance out added tightening pressures from
faster than expected growth and is likely to see policy direction stay
the path of a moderate tightening cycle.

Accordingly, we think the post data commodity currency selloff may be
overextended. AUD/USD fell off a proverbial cliff from highs around
1.0075 but was met by strong demand ahead of the 0.9825 range lows -
the pair has been consolidating within a 0.9800/1.0025 range since
1/6/11. Above 0.9825 may provide good value for longs on persistent
sideways price action. Aussie crosses have also corrected lower on the
back of China tightening speculation. AUD/CHF is currently testing key
support into 0.9450 highlighted in the Jan. 4th Weekly Strategy and
warrants bringing stops to cost as protection against a sharp upside
correction as we believe this to be a possibility when rate realities
begin to set in over rate expectations.

*A chilly fourth quarter for the UK*
The strength of the UK's economic recovery faces its most severe test
on25 January when GDP data is released for the fourth quarter of 2010.
Market analysts expect the quarterly growth rate to dip to 0.5 per
cent from 0.7 per cent in the third quarter and a whopping 1.2 per
cent in the second quarter. But the risks are to the downside.

The trade deficit increased over the quarter, which will hit growth;
also economic data released so far has shown a divergence between
different sectors of the UK economy. The manufacturing sector has come
back with a bang, and the PMI manufacturing index reached a multi-year
high of 58.3 in December. In itself, this is good news. However, the
manufacturing sector is only a small portion of the UK's economy, a
far more important sector is consumption, and there the figures are
looking grim.

Retail sales have been on a downward trajectory since October
culminating in a dismal 0.8 per cent monthly decline in sales in
December, a record drop. Although part of the decline was due to the
coldest weather in a century hitting the UK, the hike in sales tax on
January 1 suggests that retail sales will not pick up anytime soon. On
another note, rising fuel and food costs also depressed retail sales
at the end of 2010, which puts more pressure on the Bank of England.
The minutes of the latest Bank of England meeting will be released on
26 January, which should give us some idea of where the debate is
heading within the Monetary Policy Committee: to hike or not to hike?
As mentioned, there is a chance that expectations for the UK's
economic growth are overdone. If we get a weak GDP reading next week
then we could see a sharp reversal in long sterling positions. We were
wary about the sustainability of growth in the UK, and wrote in our Q1
2011 outlook that we thought 1.6000 would be a tough resistance level
for GBPUSD to break through; so far it looks that way.

*Precious Metals may enter Q1 2011 predicted "Buy zones" next week*
While the correction in gold and silver has taken a few weeks longer
than predicated in our 1Q 2011 Precious Metals Outlook, it has still
come nonetheless. The unwind since the turn of the year has been
treacherous, especially for the "poor man's gold", but ultimately
little has changed fundamentally. Much of this price action can be
attributed to a reduction of long positioning since the "doomsday"
scenario appears to be off the table. In the short-term, the market
believes troubles in both the U.S. and E.U. have abated, primarily due
to rising U.S. 2011 GDP estimates - based on the 2% reduction of the
Social Security tax and EU official's willingness to discuss a
permanent solution and/or changes to the European Financial Stability
Facility (EFSF). However, this euphoria is unlikely to last forever
and Wednesday's FOMC interest rate decision may provide a spark in
renewed interest for precious metals - Fed is likely to reaffirm their
view to keep interest rates "low for an extended period of time". We
believe gold and silver may trade down into the $1300-25 and $26-27
regions next week and could be an attractive area to establish a
bullish bias over the coming weeks and months. Alternatively, buying a
dip in XAU/EUR between €970-80, for those who prefer to remove the
USD variable, could also be an idea.

*Key data and events to watch next week*
Unites States:
* Tuesday - Nov. S&P/CaseShiller Home Price Index, Jan. Consumer
Confidence, Nov. House Price Index, Jan. Richmond Fed
Manufacturing Index, Weekly ABC Consumer Confidence
* Wednesday - Weekly MBA Mortgage Applications, Dec. New Home Sales,
FOMC Interest Rate Decision
* Thursday - Dec. Chicago Fed Nat Activity Index, Dec. Durable Goods
Orders, Weekly Initial Jobless & Continuing Claims, Dec. Pending
Home Sales
* Friday - 4Q Employment Cost Index, 4Q advance GDP, Jan. Univ. of
Mich. Confidence
Euro-zone:
* Monday - EZ, French and German Jan. Advance PMI, EZ Nov.
Industrial New Orders
* Tuesday - French Dec. Consumer Spending, French Jan. Business
Survey Overall Demand, German Feb. GfK Consumer Confidence Survey,
EU's Barroso and Van Rompuy Speak
* Wednesday - French Dec. Jobseekers, ECB's Stark Speaks
* Thursday - EZ Jan. Business Climate Indicator, EZ Jan. Confidence
Readings, German Jan. preliminary CPI, ECB's Bini Smaghi and
Tumpel Gugerell Speak, EU's Van Rompuy Speaks
* Friday - EZ Dec. M3, German Chancellor Angela Merkel Speaks
United Kingdom:
* Tuesday - 4Q advance GDP, Nov. Index of Services, Dec. Public
Finances
* Wednesday - BOE Minutes, Dec. BBA Loans for House Purchase, Jan.
Hometrack Housing Survey
* Thursday - Jan. CBI Reported Sales
Japan:
* Monday - Dec. Supermarket Sales
* Tuesday - Jan. BOJ Interest Rate Announcement
* Wednesday - Dec. Corp Service Price Index, Jan. Small Business
Confidence, BOJ Monthly Economic Report
* Thursday - Dec. Merchandise Trade Balance
* Friday - Dec. Jobless Rate, Jan. Tokyo CPI, Dec. National CPI,
Dec. Retail Trade
Canada:
* Tuesday - Dec. Consumer Price Index
* Wednesday - Nov. Teranet/National Bank HPI
Australia & New Zealand:
* Monday - AU 4Q Producer Price Index
* Tuesday - AU Nov. Conference Board Leading Index, AU 4Q Consumer
Prices, NZ Dec. Performance Services Index
* Wednesday - NZ Dec. Credit Card Spending
* Thursday - AU Nov. Westpac Leading Index, RBNZ Interest Rate
Announcement, RBNZ's Governor Bollard Speaks
China:
* Friday - Jan. MNI Business Condition Survey
Source: ActionForex.Com