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Trading in the London Session was choppy with the market unwilling to take any clear direction as we lead up to tomorrow's informal EU summit. The market toyed with the idea of Eurobonds (they like that idea and risk assets may rally tomorrow on any signs they are on the horizon.) Then they focused on the prospect of a showdown between Germany and France, Europe's de facto leaders, which caused a mild sell off. Right now the chances of the latter happening are more likely especially since Merkel is unlikely to be re-elected next year if she agrees to Eurobonds (read Germany guaranteeing the bulk of Europe's debt), which would never fly with German voters.
Although the EU President said that everything is on the table for discussion tomorrow, he also said that no concrete measures will be taken. Thus, the prospect for a market disappointment remains high. But how will this translate into price action? Euro shorts remain near record levels, which have led some to believe that there is enough downside priced in for a while. But if the situation in the Eurozone gets worse (think failure of EU authorities to act combined with the outcome of the Greek election) and you could see free fall. It's unlikely that an inconclusive summit tomorrow would be enough to trigger another leg lower, although we may test the air around last week's lows of 1.2650.
The risks of a pullback may actually be higher. As we have pointed out in recent days there is a chance of a pullback in risky assets. Not only is the euro looking well oversold, but the Dollar Index is approaching key resistance above 81.50, which could trigger some profit taking by the dollar bulls after it failed to get above this level last week. Added to this the SPX 500 bounced off support just below 1,300 yesterday. For a comprehensive overview and what we think could happen to risk assets post tomorrow's EU summit check out our preview video available on our website outside of the US.
Overall, today's price action shows that although the technical picture may be ripe for a pullback, it is more complicated than that as investors remain sensitive to headline risk. The fairly well received Spanish bond auction this morning, which saw the bid-to-cover ratio rise to over 4, helped spur sentiment. However, we along with equity investors remain suspicious of the bond market in Spain due to the large amount of debt being bought by Spanish banks. This is helping to support auctions and prop up bond prices, meaning that yields are not rising as high as they might without this support. A better indicator of sentiment towards Spain remains the Ibex (the Spanish stock market) and CDS contracts for Spain's largest banks including Santander and Bankia, which remain close to their highest ever levels, although 10-year bond yields are not as high as they were in November and the yield curve (10year yields- 2-yr yields) is much healthier than it was back then. So a successful Spanish bond auction isn't giving us the real picture of the state of things in Spain.
The other big event was Japan's long-term credit rating downgrade to A+ from AA due to high levels of public debt and an inability for politicians to agree to double the consumption tax from 5% to 10%. The OECD, who delivered its semi-annual global economic outlook today, said that doubling this tax should be a top priority before 2014. The OECD delivered good news to the US, upping its growth forecast to 2.4% for this year and 2.6% next year and also expects the jobless rate to fall below 8% this year. Its outlook for the Eurozone was bleak. If the sovereign situation does not deteriorate then growth may contract by 0.1% this year (well below the GDP rate for the US and Japan), however it said that there was a risk of a deep recession if the sovereign crisis blows up. Since that risk is balanced on a knife edge, the risks to growth are very much present, which should be negative for the euro and European stocks in the medium-term. The OECD also said that Eurobonds could be one way to solve this crisis and also urged the ECB to cut interest rates (rates are currently at 1% and significantly higher than in the US where they are 0-0.25%).
The pound took a beating this morning after the IMF said the UK government needs to find a plan B if fiscal consolidation doesn't work and growth doesn't pick up. It also urged rate cuts and more QE, hence the negative impact on the pound.
After trying to break above 1.2820 for the second day, EURUSD then tumbled back below 1.2750. All these levels look a bit shaky in the short-term and before the EU summit. We continue to think that 1.2624 - the January low - will remain as key support in the medium-term.
The pound was hit hard post the IMF news, and fell sharply, although it managed to find support around 1.5820 - a cluster of daily smas. 1.5850 remains key resistance with 1.5750 on the downside. Tomorrow's MPC minutes will be vital to determine the medium-term trend for this cross as we find out just how dovish the MPC actually is. EURGBP has run into resistance just above 0.8100. This may cap the upside until we get 1, the MPC minutes and 2, the outcome of the EU summit. Support lies at 0.8050 first and then 0.8020, if the MPC minutes are deemed dovish then we may see a re-test of 0.80.
Gold has recovered this afternoon as the dollar lost some safe haven appeal after stronger than expected US existing home sales. Resistance lies at $1,595 then at $1, 1614 -the base of the Ichimoku cloud, which may cap the upside in the short-term. Gold is likely to follow market sentiment tomorrow and could break above these resistance levels if the EU summit delivers some good news.
Kathleen Brooks| Research Director UK EMEA | FOREX.com
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