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The markets are moderating as we get closer to the start of the EU summit later today. After a strong rally during the last three days cautious investors are preparing for a potential disappointment from the EU summit and pairing back their long positions. Over the last year and a half EURUSD has tended to decline between 0.5-3% in the five days after a Eurozone summit, so there is good reason for investors to practice caution.

Pressure building on Spain

However, this pre-emptive action means that the real risk is that EU politicians actually deliver the goods causing risky assets to embark on another leg higher. The goods that the market requires are Spain to apply for an aid request (or formally ask for a precautionary line of credit), which would then trigger the ECB’s OMT programme. Rating agency Moody’s stopped short of downgrading Spain to junk status on the back of the ECB buying Spanish debt through its OMT programme, so the heat is on Madrid to make a request in the coming days. There is a huge amount of pressure on PM Rajoy, not only from the rating agencies but also from French President Hollande, even Germany who had been lukewarm to the idea of Spain requesting financial assistance, said earlier this week it may support offering Spain a line of credit. The EU summit is a binary outcome: either Spain applies for funds and the OMT is triggered (risk positive), or it doesn’t and the ECB’s latest plan is still a lame duck (risk negative).

What will happen with Italy?

Let’s imagine for a moment that Spain does apply for a line of credit – the key question to ask is how will this affect Italy’s bond yields? In the past bailouts have had a domino effect with Greece toppling first then Ireland and Portugal. If Spain goes would the pressure transfer to Rome? Obviously Spain isn’t applying for a bailout and still needs to tap capital markets, which makes it a different case from the other peripheral nations, however if the ECB is standing behind its bonds and not Italy’s surely global investors will start buying more Spanish debt than Italian debt? The central bank of Italy recently reported a pick-up in international investor interest in its debt, which may be driven by expectations that Italy will also sign up to the OMT programme. Thus, if Spain does request aid this week we could see Italian bond yields start to rise until Italy follows suit. Thus, a risk rally could be short lived if Rome starts to look vulnerable, which may cap EURUSD gains.

The other question to ask is how will the OMT programme actually help Spain? Yes it may reduce its bond yields, but it is unlikely to have an impact on growth in the near term. The latest data about bad bank loans was dismal. Spain’s bad loan rate is now a whopping 10.5%, a record high. If this doesn’t reverse course soon there will be a growing suspicion that the EU60bn required to re-capitalise the banking sector announced last month may not be enough. This may mean that Spain has to request even more aid and may need a full blown bailout one day. The OMT programme does not help growth or economic imbalances in the currency bloc, thus this EU summit also needs to deliver on some growth-boosting measures, or at least come up with a better cushion in case growth rates in Spain and other peripheral countries continues to decline.

The UK set for a strong rebound in Q3

In contrast to the economic malaise in Europe, the UK economy is rebounding after a dismal H1 2012. Retail sales were the latest data surprise. They rose by 0.6%, double the 0.3% expected. The re-bound in sales was fuelled by winter clothing and a return of online shoppers in September. The sharp decline of people shopping online during August was blamed on the Olympics. Retail sales data followed more stellar labour market data released yesterday. The stars seem to be aligning for a good Q3 GDP report, which could keep the pound supported in the near term and if we continue to see positive data surprises in the UK then a re-test of 1.63 in the medium term seems possible.

One to keep watching: USDJPY reaches a critical junction

Economic data out of the US has been mixed this week. Initial jobless claims were stronger than expected last week rising to 388k from 342k last week. The recent volatility in claims could be due to seasonal distortions as we enter a new quarter. This has helped US 10-year Treasury yields fall back from the 200-day sma at 1.8%. Yields are in a very tight range at the moment, and usually when the range tightens there can be an explosive break out. The downside seems to be supported at 1.7% - the 50-day sma. USDJPY tracks yields closely, so if we see a break out in 10-year Treasuries then we could see USDJPY extend gains towards 80.05 initially. This cross is already above the daily Ichimoku cloud at 78.60 (for the first time since April), which is now key support. The next interim resistance after 79.40 is 79.65 then the big ‘old 80.00. Next week’s FOMC decision and also durable goods orders could help to determine if this pair extends recent gains. A negative outcome from the EU summit could cause this pair come under downward pressure as the yen would most likely get bought as a safe haven. Thus, USDJPY bulls need to be patient and watch economic data releases like a hawk, including the Phili Fed released at 1500 BST/ 1000 ET today. A strong number could get us above the 200-day sma at 79.40.

USDJPY: daily

Source: Forex.com

Best Regards,

Kathleen Brooks| Research Director UK EMEA | FOREX.com

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