As we head into the end of the week there is still no break in the deadlock to find a solution to cut spending and raise the debt ceiling. Since the US hits its credit limit in 4 days these are worrying times. The latest delay is mainly from the Republican caucus who can't seem to agree on a plan. This postponed a vote in the House of Representatives last night. The Republicans are due to meet at 1600 BST today to try and hash out a plan and it is expected that Washington won't be taking the weekend off.

The initial reaction was to sell the dollar, and USDJPY slumped to 77.45. The markets are brushing off intervention fears even though the Japanese Finance Minister said that the yen is strengthening too much and has deviated from Japan's economic fundamentals. He also noted that the Finance Ministry is willing to take appropriate action (read direct intervention in the FX markets) along with the Bank of Japan to stem the yen's rise.

The Japanese authorities may decide to delay intervention until there is a breakthrough in the US debt impasse. We would expect a deal, especially one that came as early as this weekend, to lead to a brief respite in USDJPY. This could be a more effective time to intervene rather than go against the tide of negative dollar sentiment that currently dominates the market.

The European debt crisis refuses to calm down. Reports today suggest that Italy's rising borrowing costs may mean that it does not participate in the next tranche of bailout funds for Greece due in September. Italian officials said it would step out of providing funds for Greece if its borrowing costs rose above the charge for Greek bailout bonds. This puts even more pressure on the core economies.

But the main focus is on Spain. It was put on review for a possible downgrade by Moody's, the credit rating agency. It justified the action because there is a good chance that high funding costs will persist for Madrid, as 10-year bond yields remain above 6%. Interestingly, it also noted that Spain's contribution to the second bailout for Greece could also put pressure on the government finances.

Spain's finances remain in a precarious state, added to that growth is already weakening at a time of harsh austerity measures. Although unemployment moderated in the second quarter it remains at an eye-wateringly high 20.89%, added to this inflation pressures in the larger Iberian nation remain elevated, with annual prices running at a 3% growth rate.

Two-speed Europe was brought into focus this morning after retail sales were released in Germany. Sales rose by a record 6.3% monthly rate in June. Domestic demand has been boosted by a tightening labour market; unemployment fell for the 25th month in a row in July. This data will help to cheer European authorities, since it shows that Europe's largest economy is holding up well even as sovereign concerns rage across the Eurozone.

However, the euro remains weak. A key resistance level is the 1.4330 pivot. It may drift around this level for some time as two opposing forces are weighing on the single currency, this should ensure volatility. Although the currency bloc's inflation estimate for July was weaker at 2.5%, versus 2.7% in June, the ECB remains concerned about inflationary pressures. Added to this, the euro's fortunes are tied to the dollar. If there is no resolution to the debt ceiling crisis as we move into the weekend it may dent sentiment towards the greenback.

Also of note today is US GDP. Although the markets have brushed off economic data and even earnings releases this week, the US GDP figure is one of the most important data releases and should help us to determine how protracted the current slowdown will be. The market expects an annual growth rate of 1.8%, down from 1.9% in the first quarter. Consumption is expected to fall, however a contraction in state and local spending may be counter-balanced by a large increase in military spending last quarter. A stronger reading, as some people are predicting, may not create a rebound in risk since a government shut-down or default would probably hurt growth later in the year.

The markets are likely to remain jittery until the political stand-off in Washington is resolved and the debt ceiling is raised. Most people still believe a deal will be agreed, but right now it looks like politicians are going to push it to the wire. Commodities, including gold, are moving in line with the dollar today. Overall, we expect safe havens and the Pacific currencies to continue to remain in demand and for the dollar to trade with a weaker bias until a US default is safely off the table.

Data Watch:
Canada 13:30BST (0830 ET) GDP (May) m-o-m 0.1% EXP, 0% LAST
United States 13:30BST (0830 ET) GDP (Annualized) (Q2 A) q-o-q 1.8% EXP, 1.9% LAST
United States 14:45BST (0945 ET) Chicago Purchasing Manager (Jul) index 60.0 EXP, 61.1 LAST
United States 14:55BST (0955 ET) U. of Michigan Confidence (Jul F) index 64.0 EXP, 63.8 LAST

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Kathleen Brooks| Research Director UK EMEA |

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