The positive rally in risk correlated trades were killed by the negative interpretation of today's Chinese data. As risk appetite headed for the exits, forex trades also move lock-in-step. The USD rallied against most G10 currencies with the CHF being the lone exception. Interestingly the EURUSD didn't react sharply, illustrating the pair's sensitivity remains focused on the EU situation. Chinese GDP growth printed at 9.8% y/y vs. 9.4% exp, up from 9.6% in Q3 2010 (putting 2010 annualized growth at a healthy and on track 10.3%). December industrial production (IP) growth came in at 13.5% y/y vs. 13.4% exp, up from 13.3% y/y in Nov. December CPI inflation fell to 4.6% yoy vs. 4.6% exp down from 5.1% in November. In total, activity growth accelerated sharply while inflation pressures remained elevated.

The numbers highlight a strong Chinese economy, but increase the likelihood that additional tools to normalize policy rates and stem inflation expectations are coming near-term (we suspect 3 more RRR hikes in 2011). On the Chinese data releases, equities headed lower with Shanghai leading the way down -2.92% (following the largest drop in US stocks since Nov. 20101) and turning European indexes futures lower. Adding to the dampening of sentiment, media reports emerged that Chinese regulators will force banks to bring 25% of off-balance sheet loans on the books per quarter. While this is old news with a bit more details, the screaming headlines didn't stop the markets from overreacting. With Asian banks notoriously stuffed with NPL, this could highlight significant weakness in the Chinese banking system.

In Europe, markets are still waiting on any indication that there has been forward progress regarding the European Financial Stability Facility (EFSF). This week's meetings were expected to set the stage for an overhaul of the agreement on the EFSF, perhaps as early as Feb 4th - the next EU Council meeting. However, what we have gotten is a lot of confusing and divergent comments. EU Commissioner Rehn stated that it's critical to increase the EFSF in order to eliminate any doubt that the markets could have regarding ability to mobilize support. However, EFSF CEO Regling stated that the current size of the rescue fund is adequate and countries such as Spain and Portugal still have access to capital markets. Overall, markets remain optimistic that an agreement will eventually be reached which has been reflected in the continued decline in CDS prices and yield spreads of peripherals vs. Germany (supported by another strong debt sale in Portugal yesterday). We also agree with this sentiment and continue to look for buying opportunities on EURUSD dips.

As for today, the focus will turn to the US and a broad slice of economic data & corporate earnings. We suspect that the positive trend in US data will continues and should be good for risk correlated trades. In addition we suspect that the initial reaction to the Chinese data was well overdone, and believe risk takers & bargain hunters will move back in near term.