* But China is the one actually raising rates: another surprise RRR
hike - inflation is still an issue
* Market's shift back to the ECB's exit policy
* EURUSD may continue to rally, but watch for a resumption of
sovereign debt fears
* Markets expect to see a solution to the sovereign debt problems in
Europe - next week's ecofin meeting is important
* US inflation data ahead is key
* Watch out for JP Morgan's results
Yesterday's post-ECB press conference was worth waiting for. The
market took Trichet's comments that the ECB had noted that
inflation, which at 2.2 per cent in December is already at a
two-year high, could rise further as a hawkish signal. In fact,
Trichet signalled that the ECB will need to see the burden of proof
from the economic data in the coming months before a rate rise. But
although a rise is not imminent, we can't rule one out later this
year.
All of a sudden we have shifted back to the pre-QE2 theme that
dominated the forex markets prior to November: the ECB's exit
strategy. The hawkish bias in the ECB is much stronger and more
powerful than it is in the Fed, and this is driving euro strength.
Although the pace of yesterday's mega- intra-day rally - EURUSD rose
more than 2.5 per cent - is unlikely to be sustained, EURUSD could
trade higher on the interest rate differential with the US moving in
the euro's favour. So the ECB don't actually have to raise interest
rates this year for the euro to trade well against the dollar, it just
has to be closer to a rate hike than the Federal Reserve.
The next level in focus for EURUSD is 1.3500, but to gauge the
strength of this rally and determine if there is potential for EURUSD
to move back toward the 1.4200 highs, we would have to see a sustained
improvement in the economic outlook in Europe and even more of a
moderation in peripheral nations' bond spreads. So euro strength is
the dominating theme for now, but it may not stay that way for long is
sovereign debt woes come back to haunt the currency bloc.
A speech this morning by Germany's Bundesbank president Axel Weber
didn't add anything else to the debate about the ECB's exit strategy.
He said that German GDP could moderate and that inflation risks were
moving to the upside, but he followed Trichet's line and said that
interest rates remain appropriate. Earlier, French finance minister
Christine Lagarde told reporters that EU officials would consider
plans to extend the size and scope of the EFSF rescue fund. Next week
the focus will shift toward the ecofin meeting and a credible
long-term strategy to resolve the sovereign debt crisis. Part of the
euro's gain this week has been due to the market giving Europe the
benefit of the doubt that it can come together and sort out the
peripheral debt mess, if it instead sees this rally in European assets
as a reason to drag their heals then we could see a quick reversal in
risk sentiment.
While Europe ponders if it can risk raising rates while the economic
recovery is so uneven, China surprised the markets and hiked the
reserve requirement ratio by 50 basis points effective 20 January.
Combined with the Christmas Day rate hike, this reinforces China's
determination to soak up liquidity and tame inflation. The rise in
food prices is of particular concern to China since food makes up such
a large part of their consumer price inflation index. Today's move
suggests that inflation is continuing to climb in the emerging market
powerhouse. China's official visit to the US next week will also be in
focus. Any sign of an escalation in currency tensions between the two
nations could hurt risky assets.
Stocks are taking a breather today after a strong run this week. But
JP Morgan's results due out at 1200GMT (0700ET) could cause a flurry
of excitement, so watch out. Oil and gold are also a touch lower after
strong gains this week; partly this is due to a stabilisation in the
dollar. The dollar index has fallen 2.5 per cent this week but seems
to be bouncing off the 78.8 level.
In the UK strong producer prices were tempered by a fall in core
producer output prices in November to 2.9 per cent, this is
encouraging due to the UK's sticky inflation problem. The pound is
fairly flat today after a strong week on the back of dollar weakness.
Sterling is not the big story in FX markets at the moment, and is
being dragged higher and lower based on where EURUSD is going.
Ahead the markets will focus on US inflation data and retail sales. A
strong reading for retail sales would cheer the economy and could
boost both risky assets, but watch out for inflation. If core
inflation remains at 0.8 per cent for December as the market expects
then the sceptre of more QE from the Fed will remain on the table,
which could hinder any dollar strength.
Source: ActionForex.Com
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