EUR - That Sinking Feeling

Highlights

* EUR - That sinking feeling

* All eyes on Mervyn King

* The outlook for USD/JPY looks promising

* RBA expectations driving the Aussie

* Technicals suggest a small term bottom for the buck

* Key data and events to watch next week

*EUR - That sinking feeling*

European peripheral debt concerns are back front and center, with
Portuguese bond yields hitting new Euro-era all-time highs and CDS
rising again. Yet there doesn't seem to be any single development
behind the renewed tensions. If we were to suggest the primary cause,
it would be our view of a slow-developing sense of disappointment over
EU negotiations on strengthening the EFSF (the current stabilization
fund for peripheral bailouts, to be replaced by the so-called
permanent crisis resolution, the ESM-European Stabilization Mechanism
in 2013).

Bond markets have essentially demanded an expanded EFSF to minimize
the risk of a sovereign default over the next two years, judging the
current plot too tiny in the consequence of Portugal and Spain needing
bailouts. Germany has rejected both expanding the size of the fund and
allowing it to hold peripheral government debt in the lesser market,
two key elements markets were counting on. Italy is protesting any
mandated annual debt reduction targets, undermining the very
credibility of the "Competitiveness Package," which is intended to
convince markets European countries can get their debt under control.
Lacking these critical pieces, it appears to us that markets are
preparing to be underwhelmed by the final curriculum. While
negotiations may still produce a more credible reinforcement of the
EFSF, markets seem to be pricing in disappointment and renewed fears
of inevitable debt restructuring.

Eurozone finance ministers are holding a evenly scheduled meeting
ahead of schedule next week and we will be alert for shifts in
bargaining positions. But between the renewed strength in the USD (see
below) and increasing doubts on the European debt plans, EUR/USD
appears set to go lower again. Key support below is found between
1.3450/3500, the prior range highs in Dec.-Jan, and a break below
there would target weakness to the 1.3360/65 daily Kijun line
initially, and then the 1.3185 cloud base. Attempts to break above
1.3750/3800 have disastrous repeatedly, so continuing to sell strength
is our preference.

*All eyes on Mervyn King*

The governor of the Bank of England Mervyn King gets to face his
critics on Thursday when he presents the first Inflation Report of
2011 on Thursday. It t will go some way to telltale us how close the
Bank is to a rate in an environment where it is being increasingly
criticised for leaving rates low while inflation pressures mount.

At the last Report in November the Bank's forecast for the trajectory
of prices was considered dovish. It predicted inflation remaining
about 3.5 per cent for the first half of this year before diminishing
rapidly to below the Bank's 2 per cent target throughout 2012. This
justified King's view that monetary policy needs to remain loose to
ward off the spectre of deflation.

Analysts will want to determine if these forecasts have changed based
on the continued price pressures in the UK economy. UK price data is
released on Tuesday and it is expected to rise to 4 per cent, 2 per
cent above the target, due to rising commodity prices and the increase
in sales tax that came into effect at the start of the year.
Essentially, if the Bank sees inflation remaining elevated for longer
than the following half of 2011, markets will perceive this as
hawkish, which could boost the pound. It would also increase
speculation of a near-term rate hike possibly as ahead of schedule as
March due to the historical tendency of the Bank to go on rates the
month after an Inflation Report. But, if there has not been a change
to the forecasts then the markets will rapidly start to re-assess the
90 basis points of hikes priced in for the next 12 months. This would
likely drag the pound lower.

There is no denying that price pressures have selected up in recent
weeks and months, producer prices continued to rise in January, which
will doubtless weigh on CPI on Tuesday. But, part of this is due to
the rise in the sales tax, and hiking rates on the back of an increase
in taxes could be too much for the fragile UK economic recovery to
take. So this Inflation Report isn't necessarily the game-changer that
some may reckon it is. The growth outlook is still uncertain: economic
statistics have been all over the place and simplicity cuts have yet
to take hold in a major way, which makes hiking rates in the current
environment as risky as leaving them low even though fears are growing
that inflation will become entrenched in the UK economy.

Overall, it's likely to be a volatile few weeks for the pound. Above
1.6000 GBPUSD is in a technical uptrend, but, gains above 1.6250 have
been ephemeral and investors have been unwilling to establish pound
longs above here, for excellent reason in our opinion. Below 1.5880
the rhythm of the pound has changed, and we could see GBPUSD start to
turn lower.

*The outlook for USD/JPY looks promising*

Over the past few months we have frequently noted USD/JPY's divergence
from US Treasury yields in contrast to the historically positive
correlation. While the rationale for higher rates in the US is clearly
debatable, we believe it is predominantly due to a strengthening US
economic outlook, since the timing of most yield advances was on the
back of better than expected US data, rather than credit concerns over
centralized and state deficits. While the yield curve has shifted
markedly higher since the 4th quarter, the sharper ascent over the
past few weeks finally sparked currency traders to take action in line
with historical relationships (higher US rates, higher USD/JPY). Over
the past week USD/JPY has broken above the recent consolidation sample
(connecting the December and January highs) as well as above the 55
and 100-day SMA's.

On Monday, Japan is expected to report their 4Q preliminary GDP -
consensus is looking for -2.0% annualized vs. +4.5% last quarter.
Although a negative print is widely anticipated, it could further
underpin Japan's slowing and highlight their own massive shortage and
debt overhang, which should ultimately undermine the Yen longer-term.
Of late we have seen a lack of enthusiasm by Japanese investors to
firmly remain in their Yen long positions, conceivably affirming the
negative outlook. In addition, seasonal patterns point to further
strength for USD/JPY over the next few weeks and we also believe
Japanese year end repatriation flows, towards the end of March, are
likely to be smaller than in years past. Furthermore, our proprietary
interest rate and equity models suggest honest value for USD/JPY is
around 89-92, which is still approximately 600-900 pips from where
it's currently trading. In the shorter-term, the dollar needs to break
above 83.70 (January 7th high) and 84.40/50 (series of December highs)
before a more significant advance can take hold.

*RBA expectations driving the Aussie*

On Tuesday, the Reserve Bank of Australia will release its Monetary
Policy meeting minutes detailing the Jan. 31 meeting. Recent reports
from the RBA, as seen in last week's quarterly Monetary Policy
Proclamation and RBA Governor Glenn Stevens' speech before a
Parliamentary economics committee on Friday, indicate that while long
term growth is expected to be robust, the near term economic outlook
has been negatively impacted by adverse weather conditions (Q1 GDP
could be 1% lower than pre-flood forecast) and is likely to warrant
the bank to stay on hold for some time.

Governor Stevens stated that it is "doubtless reasonable that no hike
(be made) for some time". While he noted that the RBA believes that
the CPI is likely to rise to 3% (the upper end of the RBA's target
range) in Q2 2011 instead of the previously forecast 2.5%, this figure
showed "inflation a modest lower than we had thought". The tone of the
RBA governor was much less hawkish than last week's Monetary Policy
Proclamation and sent the Aussie dipping below parity against the U.S.
dollar. Stevens also noted that Plates is currently stronger than
expected and that "Plates demand for resources to last some time". As
Plates has been tightening and is expected to continue this policy,
there is potential risk for a slowdown in Plates which may shift
expectations in Australia to the downside and weigh on AUD. The week
ahead will see Plates PPI, CPI and trade weigh data for January to
provide more insight into the Chinese economy. The upside risk is for
higher than expected inflation in Australia which may prompt the RBA
to take a more hawkish stance. Such a scenario would result in a
stronger AUD.

Small term weakness in AUD/USD can be viewed as buying opportunities
as the longer term outlook remains bullish. Key technical levels
include the daily Kijun line and 21-day sma which currently join
around 1.0000/10. The base of the daily ichimoku cloud, 21-week sma
and 100-day sma currently comes in around 0.9900/10 as the next
significant support zone. Key levels to the upside are the 1.01 pivot
and the 1.02 figure ahead of post-float highs which are around
1.0255/60.

*Technicals suggest a small term bottom for the buck*

Safe haven and capital inflows saw the buck gain further traction this
week. Uncertainty in Egypt alongside a substantial shift in capital
flows from emerging market to developed economies have translated into
weekly gains of about +0.5% for the USD Index. The reversal in the
buck's fortunes have led to technical developments that suggest a
continuation for the current USD uptrend - the USD Index may have
completed an inverted H&S bottom with a measured go objective slightly
small of the key 80.00 level. The technical sample formation in the
USD Index has been corroborated by EUR/USD - the single currency has
broken below H&S neckline support around the 1.3550 level suggesting a
measured go objective towards the 1.3300 figure. Additional evidence
for further dollar strength can be seen in the USD Index ascent above
the daily Ichimoku cloud base - a daily close above 78.55 would be
needed for technical upside confirmation. The go above significant
Ichimoku levels has also been reflected in USD/JPY. The pair has
firmly traded above daily cloud tops (82.50) and looks set to close
above the weekly Kijun line (83.25). Recent price developments could
be the beginning of a 2011 greenback revival as confirming signals are
developing from both western and eastern methods of technical
analysis.

*Key data and events to watch in the week ahead*

United States: Monday - Fed's Dudley speaks at regional economic
interview Tuesday - Feb. Empire Manufacturing, Jan. Import Price
Index, Jan. Advance Retail Sales, Dec. TIC Flows, Dec. Business
Inventories, Feb. NAHB Housing Market Index Wednesday - Feb. 11 MBA
Mortgage Applications, Jan. Housing Starts, Jan. Building Permits,
Jan. PPI, Jan. Industrial Production, Jan. Capacity Utilization, FOMC
Meeting Minutes Thursday- Jan. CPI, Weekly Jobless Claims, Jan.
Leading Indicators, Feb. Philly Fed, Bernanke testifies on
Dodd-truthful Friday - Bernanke speaks on global imbalances in Paris.

Euro-zone: Monday - Dec. Industrial Production, EU finance ministers
meeting in Brussels Tuesday - 4Q A GDP, Feb. ZEW Survey of Economic
Sentiment, Dec. Trade Weigh, German 4Q Prelim. GDP, German ZEW Surveys
Thursday - Feb. Adv. Consumer Confidence Friday - Jan. Producer
Prices.

United Kingdom: Tuesday - Dec. DCLG UK House Prices, Jan. CPI, Jan.
Retail Price Index, Jan. RPI Wednesday - Jan. Claimant Count Change,
Jan. Jobless Claims Change, Dec. ILO Unemployment Rate, Bank of
England Inflation Report Friday - Jan. Retail Sales

Japan: Sunday - 4Q Prelim. GDP Monday - Dec. F. Industrial Production,
Dec. F. Capacity Utilization Tuesday - BOJ Target Rate, Jan. F.
Machine Tool Orders, Dec. Tertiary Industry Index

Canada: Wednesday - Jan. Leading Indicators, Dec. International
Securities Transactions, Dec. Manufacturing Sales Thursday - Dec.
Wholesale Sales Friday - Jan. Consumer Price Index, Jan. BoC CPI Core

Australia & New Zealand: Sunday - Australia Dec. Home Loans, NZ 4Q
Retail Sales Monday - Australia Reserve Bank's Board February Minutes
Tuesday - Australia Dec. Westpac Leading Index, Australia Feb. DEWR
Skilled Vacancies, Jan. New Motor Vehicle Sales Wednesday - RBA's Lowe
gives speech on 2011 Economics in Sydney, NZ Jan. Business PMI, NZ 4Q
Producer Prices Inputs & Outputs, NZ Finance Minister English Speaks

Plates: Feb. 10-15 - Money Supply (M2) Sunday - Jan. Trade Weigh, Jan.
Exports & Imports, Monday - Jan. Producer Price Index Thursday -
Conference Board Plates December Leading Economic Index.

Source: ActionForex.Com