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Risk is once again off today as the dollar continues to find buying interest. This is the third day in a row that the dollar has risen -so is this a trend and has the QE3/ Draghi OMT boost to the markets already lost steam? We are unsure at this stage, although we believe that dollar gains will be limited by the prospect of more QE from the Fed (especially if the labour market doesn't start to pick up). However, the success, or not, of the ECB's OMT programme all depends on Spain requesting another bailout, and right now that does not seem to be on the cards.

Is the OMT running out of steam already?

Spanish bond yields are once again proving to be an area of concern for investors. The run up to 6% at one point this morning weighed heavily on risk markets including the euro. Surely the OMT programme, the ECB's "big bazooka" can't be losing its potency that quickly? Although Spanish 10-year yields had backed away from this level by mid-morning after a strong Spanish auction, yields are not moving in the right direction and life above 6% will not be very comfortable for the ECB.

Banks in Europe remain a concern

The auction for 1-year and 1.5-year Spanish notes earlier was a success for Madrid, which took some of the pressure off the peripheral bond market. However, debt at this maturity should not be hard to sell since debt with a maturity of 3-years or below is covered by the ECB's OMT programme if Spain decides to request formal assistance from the EU/ ECB/ IMF. Thus, it is no surprise that 18-month debt yielded 3.07% and 1-year debt yielded 2.85%, both a sharp drop in cost compared with what Madrid had to pay at auctions prior to the ECB meeting earlier this month. Thursday's auction could be a tougher sell as Spain tries to shift 2015 and 2022 bonds. However, we know that banks are still purchasing sovereign debt, which could make it harder for the banks to recover in the long-term. A report from the ECB also found that although lending to the wider economy shrunk in Q2, the pace of decline fell relative to Q1 possibly due to the ECB's LTRO programme and the cheap credit it is extending to the banking sector. This is significant because it suggests that the banks' de-leveraging process has not begun in Europe and the non-financial economy remains as reliant on banks as ever, which in some cases makes them too big to fail. This also makes it harder for Europe's banks to purge the bad debts on their balance sheets, which in turn keeps the negative feedback loop between sovereigns and their banking sectors. Thus, as long as banks balance sheets continue to look bad it's hard to see how the OMT can solve the long-term, deep-rooted problems in the currency bloc. This is not helped by the EU showing signs of division regarding banking reform and banking union. This is now unlikely to come into play by 1 Jan 2013, which may spook investors in the medium-term.

In the near term we could see a further correction in EURUSD, although we expect 1.30 to act as an extremely tough support zone due to the psychological importance of this level. If we get below 1.29 then it would suggest that the markets have lost faith in the ECB's Drgahi and his pledge to do "all it takes" to save the Eurozone, and we could be headed back to the 1.25 area or even lower in the medium-term.

Economic doldrums

The economic data is not supportive of a stronger euro. The German ZEW's current situation index fell sharply in September to 12.6, its lowest level since 2010. The forward-looking indicator picked up slightly but still remains extremely weak at -18.2. The market will be watching the flash September PMI readings that are released on Thursday for more clues as to the growth trajectory of the currency bloc. These readings are expected to pick up but remain deep in contraction territory, which could also leave the euro vulnerable as we progress through the week.

Petrol prices a concern for the UK consumer

Elsewhere, inflation in the UK was in line with expectations at 2.5% for August, led lower by declines in clothing and footwear costs and also in gas prices. Petrol prices rose over the month, but not by enough to push up the index. Prices continue to moderate back towards the 2% target set by the Bank of England; however the rise in petrol prices and oil prices of late remains a concern and could exert upward pressure on CPI in the coming months. Right now, though, this data does not have immediate bearing on the future direction of BOE policy as it supports the Bank's wait-and-see stance.

Investors not biting the Apple at $700

The China/Japan headlines are also weighing on risk sentiment today and taking over from the Middle East as the main geopolitical concern. If protests between the two nations increase then it could cause risk appetite to drain and volatility to spike. Interestingly, the Vix index remains at incredibly low levels even though stocks are lower and Spanish bond yields are higher. This divergence may not persist, so beware of rising volatility in the coming days. Also, watch out for Apple, which is a good overall sentiment indicator for the markets. Even after good news about pre-sales for its iPhone 5 it couldn't break above $700 per share. We will be watching this mega-cap stock today to see if it manages to crack this level and bring the market with it or if it signals a wider draining of sentiment in the market.

One to watch: AUDUSD

This pair is one to watch closely over the coming days. It has fallen sharply in the last two days on the back of some weak data coming out of China and dovish RBA minutes overnight. It is testing its 50-day sma at 1.0415, and if breaks below here it opens the way to a steeper decline to 1.0325. We mentioned yesterday that the double top at 1.0625 was a potential reversal pattern, and today's price action confirms that reversal. Since this pair is sensitive to market sentiment watch where it goes as a measure of overall risk sentiment. It is starting to look oversold in the short-term, but we expect any pullback to be shallow potentially to 1.0450 then 1.0480 before the sellers come back in.

AUDUSD: Daily chart


Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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