Just as most risk indicators were starting to improve in tandem, economic news from both the FOMC and from China have thrown a spanner in the works. That said the tone has improved in Europe on news of another good set of results from the Spanish bond auction and from news of a proposed merger in the Greek banking sector.

The FOMC last night reduced its 2010 growth forecast to 3.0% to 3.5% from a previous forecast of 3.2% to 3.7% as its members commented that the need to consider further stimulus might become appropriate if the outlook were to worsen appreciably. While there is next to no risk that the Fed are poised to loosen policy again imminently, the recognition that further easing may be the next policy step is in marked contrast to speculation that the Fed could hike by year end; this being a central market view just a few months ago. The tone of the Fed was not, however, a surprise. Even allowing for the recent better sentiment in US stocks, the S&P 500 remains 10% below its April high. The correction in risk assets during the spring can be linked with the softer tone of US data. While the decent start to Q2 earnings season has lifted some of the gloom in stock markets, fears that Q3 could be a tougher trading environment is likely to cast a shadow on this outlook. Chinese data are likely to underpin these fears. Chinese growth in Q2 slowed to 10.3% from 11.9% in Q1. The recent release of strong Chinese export data confirmed that external demand has been underpinning Chinese growth. Domestic demand, however, has been more subdued. China has taken several steps this year to slow activity in some assets market in particularly the property market. Global growth prospects in H2 could be blighted by the coincident impact of Chinese monetary tightening and the fiscal retrenchment that has already commenced in most of the industrialised world.

The possibility that the next Fed policy move could be an ease is a negative factor for the USD. That said this impact will be offset by the dollar’s position as a safe haven. Sterling has managed to appreciate vs the USD this morning with cable pushing against the USD1.5340 level supported by the suspicion that the BoE could beat the Fed into hiking rates. The EUR has also made some gains with EUR/USD registering a intraday high of USD1.2803. The Spanish 2025 bond auction results boast a solid 2.57 bid/cover ratio. The average yield was squeezed to 5.116%, although the debt office achieved its aim by selling EUR2.99989 bln meaning that once again these result lie at the better end of market expectations. The spread of Spanish – German bond yields narrowed on the result. Also providing a diversion for the euro this morning was the surge in Greek bond shares on the news that Piraeus Bank has submitted a proposal to buy significant stakes in two smaller Greek banks. Allowing weaker banks to be absorbed could reduce the risk of bank failure and provide an alternative to government support.

The better news in Europe this morning has allowed the JPY to give up some of its overnight gains on the crosses. AUD/JPY has pushed higher as has AUD/USD, though both remain below last night’s closing levels. Fears of a moderation in Chinese domestic demand will continue to hinder the medium-term outlook for the AUD.

Earnings will remain in focus this afternoon. US PPI and initial claims and Canadian motor and manufacturing sales data are due.