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There has been a lack of conviction in the markets this morning. EURUSD has fallen back from its 1.2810 high, and stocks are mixed to slightly lower since the London open. After their sharp falls on Friday, Spanish bond yields have started to climb higher, but not worryingly so. The 10-year yield is now at 5.65%, however, Spain may end up being the undoing of the ECB's latest sovereign rescue plan as low or falling bond yields make it less likely that Madrid will formally request aid, which is needed to trigger the ECB's bond-buying programme into action.

Some good news for the euro

But problems with Spain are not on the markets' minds right now, and instead we are seeing a very normal pullback after the sharp move higher that we saw on Thursday and Friday of last week. EURUSD has jumped by 300 pips, so a breather at 1.28 is perfectly normal and does not suggest that the euro/ risk rally has run out of steam yet. It seems like the German Constitutional Court ruling and the Dutch elections (both due on Wednesday) could actually extend the rally in the euro that we are seeing. If the Constitutional Court votes that the ESM is legal as we expect and if the Liberals win in the Netherlands then we could see EURUSD get over the 1.2885 mark - the 200-day sma.

Expectations weigh on the Fed's shoulders

However, there are a good few potholes in the road for risk assets this week. The first is a disappointment from the FOMC when it announces its policy decision on Thursday evening London time. The rally in risk and the euro have partly been fuelled by expectations of QE, so if Bernanke and co. at the Fed only announce an extension to their commitment to keeping interest rates low for a prolonged period, maybe out until 2015, we believe that it won't cut it for the risk bulls. They expect full blown asset purchases of at least $500bn. Watch out for our fundamental update of what to expect from the FOMC meeting for a more detailed review, but one thing to note is that in past the markets have not reacted in the way you would expect on the announcement of more QE, and in fact the bulk of the risk rally happens before the Fed turns on the dollar printing presses.

Spain - could render the OMT obsolete

The second risk to watch out for is Spain. As we mentioned in our week ahead, the ECB's new OMT programme does not help improve the stability of the Eurozone without Spain requesting a full blown sovereign bailout or at the very least a precautionary line of credit complete with conditional requirements in return for financial support. Newspaper reports at the weekend suggested that Spain may wait until after regional elections on 21st October before formally requesting aid, which would leave the OMT fairly redundant until then. Investors might not have the patience to wait until then and could push Spanish yields higher again. October is a big month for Spain - it has a EU20 billion bond redemption payment and also a packed schedule of debt issuance along with the regional elections. There may be some expectation in the market that Madrid will formally request sovereign aid at this weekend's Eurozone finance ministers' meeting. However, we don't think it will, which leaves the euro vulnerable from a loss of risk appetite next week even if the Fed does deliver the QE goods.

Can the Aussie keep up with the risk rally?

Elsewhere, weak Chinese data knocked the Aussie off course overnight as it rejected 1.04 for the second time after backing away from this level on Friday. This now looks like a double top and could prove temporary tough resistance. Support lies at 1.0320 - a cluster of daily moving averages. There isn't too much economic data to drive the Aussie this week, so we expect it to move with overall risk appetite in the medium-term.

One to Watch: USDJPY

Japan has also been in the headlines. A news agency has reported that the Bank of Japan will downgrade its economic assessment at its next meeting after GDP data for Q2 was revised lower to a mere 0.2% from 0.3% previously. However, USDJPY remains steady above 78.00 at 78.30. 78.00 is key support level dating back to the start of the year, so this level is likely to remain sticky. A big bazooka from the Fed could see this cross fall below 78.00, however a QE plan of approx. $500 bn may not be enough to push this pair down lower and we could meander back towards 78.70 - the base of the daily Ichimoku cloud - and then to 79.00 post the Fed meeting later this week.

USDJPY daily chart: 78.00 is a key support level that has held during the recent sell off. It is also the double bottom from May. Below here opens the way for a move back towards the February lows of 76.00.


Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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