Still not much activity in the Asian session as the region remains in New Year's holiday mode. The one exception was the AUD which continued its strong rally. AUDUSD ran up to 1.0196 as the RBA's Statement on Monetary Policy predicated that the effect of the Queensland floods would be temporary and felt no need to revise their growth or inflation forecasts lower. In fact GDP forecasts for 2011 were increased to 4.25% from 3.75% in the earlier statement. Today's statement echoed the RBA comments earlier in the week (which helped trigger the AUD reversal) and supports our view that the market had become overly dovish on the expected rate path. We still see three 25bp hikes in 2011, putting the cash rate at 5.50% by year end. With this current base scenario we suspect the interest rate differential trade will keep one of the highest yielders in the G10 well supported. However, despite reports that Australia's commodity infrastructure is largely unaffected, commodities continues to rally (copper & crude) which suggests that inflation should accelerate in both developed and EM countries alike. While some central bankers remain insistent that the effect on headline inflation is short term, we suspect they are once again under-estimating the follow through of persistently elevated commodity prices. We suspect that rate paths will steepen significantly by Q3 and become the dominant theme of 2011.

The EUR selloff yesterday was clearly triggered by the market's over enthusiastic expectations for a hawkish Trichet. Despite the basically unchanged statement from the ECB president, the market was clearly positioned for tightening. The stark realization that rate hikes were not immediate sent speculative long positions to the exits. German Chancellor Merkel had some hard words and cold water for the much anticipated comprehensive agreement saying there will be no solid decisions at the upcoming EU summit. She added that the Eurozone would need to move ahead with agreements on solidity, growth and competitiveness for all members because if the EUR failed, then so would Europe. We had anticipated a slightly larger correction in EURUSD but are now neutral ahead of the critical US payroll & unemployment report this afternoon.

We are already seeing FX markets trading sideways as traders are either positioned already or content to see where the numbers land. The US economic data this week has had a slightly positive tone, including yesterday's non-manufacturing ISM which jumped to the highest level since 2005 and jobless claims which fell slightly more than anticipated to 415k. ADP jumped to 187k vs. 140k exp on Wednesday, while ISM suggests that labor market conditions have improved both in manufacturing and non-manufacturing, giving today's data an upwards bias. However, the disruptive weather in the US also gives this release an unpredictable feel. Expectations for today's NFP are for +146k (compared to 103k prior), private payrolls 145k compared to 113k prior), and unemployment is expected to climb to 9.5% vs 9.4% prior reading. What makes this event even more interesting is the recent public comments regarding the potential of QE3 being heavily data dependant. The historically hawkish Kansas City Fed President Hoenig said another round of bond buying may get discussed if the economic data was disappointing., while Fed Chairman Bernanke stated that Until we see a sustained period of stronger job creation, we cannot consider the recovery to be truly established. The USD is hanging the balance right now. Should the payrolls show improvement watch for the US / German yield spread to tighten and drive EURUSD higher. However, should the fragile recovery continue to avoid adding jobs, discussion of another round of easing will amplify, and the greenback will be in big trouble.