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The markets are trading with a risk off tone at the start of the week. There are a couple of reasons for this: 1, the extent of the moves last week may justify a pullback at this stage, 2, the focus turns back to growth as we await a plethora of economic data due in the coming days and 3, problems with Spain.

Spain is probably the biggest cause for concern in the coming days, although China's manufacturing PMI reading for September due to be released on Thursday could also cause some volatility especially in AUDUSD. 1.0625 appears to be a double top in this cross. Since it is so sensitive to risk, if the bulls can't push AUDUSD above this key level then we have to wonder if the rally we have seen across risk assets will permanently start to lose steam.

The "New Normal"

However, in the new normal that we find ourselves, where central banks control the direction of markets, terrible US data can be perceived as good news by the financial markets if it extends the prospect of more QE from the Federal Reserve. This was in evidence after the release of terrible Empire manufacturing index for September a little while ago. The index plunged to its lowest level for two years and was dragged lower by new orders, employment levels and shipments of orders suggesting that export demand is weak. The detail of this report was extremely weak, and does not bode well for GDP in the third quarter, especially after weak ISM manufacturing data for August, poor payrolls and also weak retail sales once you stripped out gasoline and auto sales.

The US economy has undoubtedly weakened over the summer months but the question we now have to ask is if QE3 will be the panacea it is expected to be. If investors start to doubt the effectiveness of asset purchases by the Fed then it is hard to see how this rally can be sustainable for the medium-term. The markets may have jumped on the back of Empire manufacturing data today, showing that there is some faith that QE3 will boost economic data; hence EURUSD surged to fresh highs above 1.3170. Yet again this level acted as stiff resistance, but it suggests that QE is still charging the bulls; in the aftermath of the Empire reading the Eurostoxx index also recovered some of the day's losses.

Can the Fed propel the risk rally?

For the short term it is likely that the prospect of more QE from the Fed and loose monetary conditions should be able to sustain EURUSD above 1.30. But the life above this level is far from certain for this cross. Firstly there could be some doubt about the benefits of QE3, and secondly Spain could be a spanner in the works for the ECB's latest attempt to stabilise this crisis. The Eurozone finance ministers' meeting this weekend passed off without Spain asking for a bailout. It is now unlikely to ask for a bailout before the regional elections next month. Added to this there is some concern that a pan-European banking union won't be in place by January 1st, the original deadline, which is leaving investors' worrying whether or not the Eurozone authorities are really committed to the structural reform necessary to get the currency bloc out of the sovereign mess.

China diverges from the Fed

Added to that, it appears that China may not follow the US and pump its economy full of stimulus, which is particularly worrying for Aussie bulls. The state news agency said that more stimuli could actually hurt the economic recovery, presumably because of the inflationary effect. The Bank of Japan meets on Wednesday and there is some speculation that it could also do more QE to keep up with the Fed. However, the yen has fallen nearly 5% since peaking in July, so the BOJ may decide that the ECB and Fed are doing the heavy lifting, even though we expect the Bank to be on its guard regarding upward pressure on the yen.

Ahead this week, UK CPI tomorrow should be interesting for cable, the BOJ and flash PMI readings for the Eurozone are also worth watching.

One to Watch: EURUSD

The bulls have proven that they aren't giving up on the power of QE to generate a rally quite yet. Weak US economic data has caused markets to reverse earlier losses (see more above). EURUSD has yet again tested the 1.3175 resistance level, which is a short-term top in this cross. The daily chart does not look overbought after the earlier pullback so we could go back to test 1.3200 and even higher in the coming days. We tend to think we could have another few hundred pips in this rally, and we don't think it is over yet. Because the Fed has tied future QE to the performance of the labour market then there is the potential for volatility around major data releases in the short to medium term.

Above 1.3185 opens the way to test 1.3225 then 1.3330 - the base of the weekly Ichimoku cloud. 1.3155 then 1.3095 are key support levels in the short term.

EURUSD: Daily chart

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Source: Forex.com

Best Regards,

Kathleen Brooks| Research Director UK EMEA | FOREX.com

d: +44.(0).20.7429.7924 | f: +44.(0).20.7929.2010 | M: +44 (0) 7919.411.957 | e: kbrooks@forex.com| w: www.forex.com/uk

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