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The big news of the day was that the performance of the Eurozone economy in the second quarter was not as bad as expected, France and Germany were slightly better (even if France managed to avoid a negative second quarter through a statistical quirk!) and the US consumer is back spending again, according to the July retail sales report. This along with some headline risk from Europe (albeit fairly sporadic during holiday season) has kept markets fairly lively this morning - but in these types of markets lively is a relative term.

Interestingly the markets have been able to ignore the news from LCH Clearnet that it was raising the margin requirements for some Spanish and Italian debt. It wasn't that long ago that the markets would have had kittens over a headline like that, but with 2-years of sovereign debt experience the markets are fairly happy with Spain balancing on the precipice of bailout territory and Italy not that far behind. The real threat came from a headline from the newswires which suggested that the German Constitional Court would be referring the ESM long-term rescue fund to the European courts to check its legality. However, the prospect of a sell off in risky assets was averted when the "source" said that it would not delay a decision by the Germans on whether or not it "could" support (and fund) the ESM. Combined with the lack of bad economic news today the markets found an excuse to rally.

Can we rely on France and Germany to prop up growth?

This manifested itself in EURUSD, which rose as high as 1.2385 at one stage. This is now looking like a double top as it was also the high that the markets rejected last week. So is the better than expected economic data out of Europe enough to sustain the rally in the euro? I believe not on two accounts: 1, French GDP was revised up to 0% (it was only a touch negative, but you see my point). Added to that household consumption in Q2 fell, while public expenditure rose sharply. In these austerity times you cannot count on public spending propping up growth in the future. Imports were much stronger than exports and investment was fairly strong in Q2, which may not be so forthcoming in the third quarter. And it wasn't just France that we are questioning. Germany may have surprised the markets by rising 0.3% on the quarter, but the ZEW survey of investment confidence saw its economic expectations index plunge to the lowest level since December 2011, which suggests the biggest economy in the euro area may not be able to keep up the pace of expansion later this year.

Inflation in the UK takes the markets by surprise

Prices in the UK defied expectation and jumped to 2.6% from 2.4% in June. The biggest upward effects came from transport, where prices rose by a whopping 1% between June and July this year. Interestingly it was flights that had the largest upward impact, especially flights to European destinations. Perhaps it was all of that poor weather in June that caused a surge in bookings for foreign holidays to warmer climes. In a turning of the tables' petrol and diesel prices actually fell in July, although the recent upward pressure on the pil price could negate these effects. Clothing and footwear were also a contributor to inflation after the summer sales seemed to have disappointed. The ONS data found that clothing prices fell 2.6% between June and July this year compared with a 3.5% fall last year. This is the smallest fall between June and July since the series was launched in 1996. This could be a case of retailers keeping their prices high for the Olympics and we could get bigger discounts later this year as the Olympic effect start to wear off.

One to watch: GBPAUD

Overall, inflation in the UK supports the BOE's cautious stance at its Inflation Report last week and is also supportive of sterling. It surged above 1.57 on the news, even though it has since fallen back as the dollar caught up post the tronger than expected retail sales in the US. GBPAUD could be the bigger beneficiary from a more hawkish BOE (we get the August minutes tomorrow) and this has been one of the top performing sterling cross today. Above 1.4950 leaves 1.50 in view (the Kijun line on the cloud) and if it can clear that hurdle then 1.5220 - the 50-day moving average - in the medium-term is a possibility as the BOE seems less likely to pump more QE into the system if price pressures come back to haunt the UK economy. However, while inflation may not fall as fast as it has been of late, we don't believe price pressures are burning or going to go back to the October 2011 5% highs, as there are some special factors weighing on prices that will start to dissipate as we progress through the year.

GBPAUD: daily

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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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