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The markets seem to be getting a little jittery as we lead up to the ECB meeting and narrow ranges abound. EURUSD gave up the 1.26 handle just before lunchtime in the London session after some news came out that said Spain would inject debt rather and cash into its struggling banking behemoth Bankia. This is a bridging loan before Bankia has access to the EFSF/ESM banking bailout funds of up to EUR100 billion. However, the decision to use debt rather than cash does two things: 1, make Bankia's debt load worse (could be seen as negative) and 2, preserve much-needed cash for the Spanish government to pay other bills including a EUR20 billion bond redemption that is coming due next month (slightly positive).

Madrid's giant banking headache

The latest Spanish news has taken the edge off the euro yet Spanish bonds have surged and yields are more then 25 basis point lower compared to this morning. It's difficult to read the markets' reaction. On the one hand the fact that Madrid is injecting EUR 4.5 billion of debt into Bankia instead of cash makes it less likely that Spain will request EFSF/ ESM aid in the short term (although in the longer term we think they will request a bailout by year-end), which makes official ECB action to buy Spanish bonds less likely. However, on the other hand, sovereign bond yields could be falling as Spain's government takes action to deal with the problem of Bankia rather than leaving it hanging over the state finances as it has been in recent months. However, we still need to find out the results of Spain's deep dive into its banking sector to try and find the extent of bad debts its banks' balance sheets that should trigger another round of re-capitalisations, so Spanish banking risk remains a threat to euro strength in the coming weeks.

EURUSD rally loses steam, but may not be over

The other euro-negative headline was the downgrade to Moody's outlook of the EU's credit rating to AAA with a negative outlook. This isn't all the Eurozone's fault, the UK's weakening economy and heavy debt load also tipped the balance in favour of a downgrade. Although Spanish and Italian bond yields have fallen sharply, the euro has come off its highs. However, the bond market tends to lead other risky assets, so I tend to think the euro could base in the coming hours before re-testing some of the recent highs. Key support in EURUSD lies at 1.2575 - Tenkan line on daily cloud then at 1.2555. A pullback to 1.2575 level may attract some buying interest back to the 1.2610 then 1.2640 level - a key resistance level after the bulls have not been able to extend gains past this level so far in the last few days. A similar resistance/ sell zone has emerged in EURJPY. After heavy buying from Japanese retail names EURJPY was sold off at 99.00, it has found good support so far at 98.70. Below there 98.50 - the bottom of the recent range - could provide a short-term support level. See One to Watch below.

Could inflation tie the ECB's hands this week?

Economic data has taken a bit if a back seat today as it has mainly been second tier data. In the Eurozone Spanish unemployment was higher than expected for August rising 38.2k on the month, the first increase since April. Producer price data for July was also stronger than expected at 0.4%; the consensus had been for a 0.2% gain. The annual rate is 1.8%. Although this is below the ECB's 2% target rate, this data along with the increase in CPI in July could make the ECB think twice about cutting interest rates at its meeting this week. The market expects rates to be cut to 0.5% from 0.75% currently. A rate cut could placate the markets in the event that the ECB isn't ready to announce its bond-buying programme quite yet. However, the hawkish faction at the Bundesbank could put a stop to a rate cut if it believes inflation is a threat. So watch out for a rate cut and bond buying disappointment from the ECB this week. If that happens then the impact on the euro could be initially negative (potentially testing 1.2450 - top of daily Ichimoku cloud - in the near term) but then we could see EURUSD bounce back towards the 1.2600 zone as the euro benefits from a yield differential with the USD.

Watch the US ISM (like Bernanke and co. at the Fed)

Later this afternoon the data from the US gets more interesting. The ISM manufacturing report from the US is pivotal as it has a close relationship with US GDP. The market expects a slight increase to 50.0 from 49.8. If consensus is correct it would be the first reading in expansion territory since May. After Bernake's Jackson Hole speech, which seemed to suggest that more asset purchases in the form of QE are contingent on economic data releases remaining weak in the coming months, then the ISM data later today is one part of the QE puzzle and investors should watch out for it closely. A strong number could see the dollar rally as QE expectations fade, while the a weak number may do the opposite now that central banks seem to have control of price direction.

It feels like the quiet before the ECB/ NFP storm later this week. Ranges are likely to persist for the next day or so as positioning comes into play prior to the ECB meeting g. A lot is expected from Draghi; watch out for our ECB preview tomorrow to see whether we think he will deliver...

Data Watch:

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One to Watch: EURJPY: trading the range

We are interested in a short-term trade in the lead up to the ECB (I definitely don't want to hold a trade during or just before the Draghi press conference on Thursday). Trading the EURJPY s/t range could be a good option. While we don't think that the bulls will manage to cause this pair to break out above 99.00, we would look to buy on any further dips to the 99.50 mark. This pair has already come off this morning, but it still has approx. 20 pips to go before it gets to our target entry level. If it doesn't get down there then I will let this one go. I would like to buy at 98.45, looking for a move back to 99.05. My stop will be tight at 98.25. That is a 2:1 Risk reward ratio. Not my normal 3:1, but as I said I am only looking to trade short term and try to scalp a few points trading this range as we lead up to the ECB. Trends and break outs are not for today - they may come later this week.

 

EURJPY: Hourly chart. The range is marked by the blue horizontal lines.

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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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