The markets have been fairly quiet so far due to Chinese New Year and investors wary of taking positions in the single currency prior to the European Central Bank meeting later today. The main focus has been on the UK this morning and the sharp turnaround in economic data. The services sector PMI rose to 54.5, smashing expectations of 51.3, and a strong pick up after the index fell into contraction territory in December. This has added to speculation that fourth quarter GDP may now be revised higher, or at the least was an anomaly and not a good representation of the underlying strength in the UK's economic recovery.
This adds to the headache for the Bank of England: mixed signals coming from the economic data along with stubbornly high inflation and two members of the MPC now calling for a rate hike, who would want to be Mervyn King right now, especially with the prospect of the February Inflation Report due next Thursday... GBPUSD was given a boost by the services sector data and is currently trading above 1.6200 in line with stronger Gilt yields, which have continued to break higher. The 2-year yield is currently above 1.5 per cent and is at its highest level since June 2009. The spike in Gilt yields has also boosted the spreads between UK and German yields, which has started to narrow. This has pushed EURGBP back below 0.8500.
As we progress through the European morning the focus is starting to shift to the ECB meeting later today. The future trajectory of EURUSD rests on ECB President Jean-Clause Trichet's shoulders. If he picks up where he left off back in January and highlights the upward risks to inflation that would be euro positive and we could see EURUSD at 1.40 in the coming days. For this to happen he would need to reinforce the ECB's determination to maintain price stability and its inflation-fighting credibility, which would drive the spread between European (German as proxy) and US 2-year bond yields to fresh highs. If, on the other hand, he emphasizes the temporary nature of the spike in inflation and the risks to growth then this would be euro negative. Although retail sales fell -0.6 per cent over the month to December other economic signals are getting stronger including the PMI services and manufacturing data. The composite PMI for the entire Eurozone in January rose to 57.0 from 56.3 in December. Admittedly this was due to strength in the core economies, but the inflation threat from a strong Germany is very real and something the ECB will want to avoid.
The ease with which the markets shrugged off yesterday's Irish debt rating downgrade (I assume most people were more shocked that Ireland's sovereign rating hadn't already been cut further by now) and instead focused on plans to announce a long-term rescue package for troubled sovereigns next month, provides a favourable backdrop for the euro to appreciate. But the main message today is to expect fireworks at 1330 GMT when Trichet kicks off his press conference. The rate decision itself should be a non-event at 1245GMT, as rates are expected to remain on hold at 1 per cent.
Elsewhere, the Kiwi dollar suffered after weaker than expected employment data, but NZDUSD is finding support at 0.7700 for now. The cyclone that hit Queensland in Australia was not as devastating as first feared, which has lent some support to the Aussie, along with reports that the December trade balance was stronger than expected, easing concerns that disruption caused by flooding hurt exports.
Stocks are down slightly while oil is still climbing higher on the back of an escalation in the political unrest in Egypt. But so far today the markets seem fairly satisfied that events won't spread to the rest of the Middle East. Gold isn't attracting safe haven flows and the Vix index or Wall Street's fear gauge, has also retreated.
Also bear in mind that Fed Governor Bernanke speaks at 1800 GMT and the EU authorities meet for their monthly summit today. Already France has come out and said it is not in full agreement with Germany on the future of the EU rescue fund. So although we are closer to a long term solution to the sovereign debt crisis, nothing is signed, sealed or delivered. If politicians disappoint this could hurt sentiment toward euro assets, although in our view it would hurt credit markets first and push up peripheral bond yields once more, before affecting the single currency.
12.45 GMT (0745 ET) EU ECB Interest rate announcement Last 1.00 Exp 1.00
13.30 GMT (0830 ET) EU ECB Press conference Trichet Speaking
13.30 GMT (0830 ET) US Initial Claims Last 454K Exp 420K
13.30 GMT (0830 ET) US Productivity Last 2.3 Exp 2.0
13.30 GMT (0830 ET) US Labour Costs Last -0.1 Exp 0.2
15.00 GMT (1000 ET) US Factory Orders Last 0.7 Exp -0.5
15.00 GMT (1000 ET) US ISM Non Manufacturing Last 57.1 Exp 57.1
18.00 GMT (1300 ET) US Bernanke speaking
22.30 GMT (1730 ET) US Duke Speaking
Kathleen Brooks| Research Director UK EMEA | FOREX.com
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