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There are a couple of themes dominating a fairly quiet Friday. The first is the Eurozone after headline risk came back with a vengeance. Firstly there was the German Chancellor Angela Merkel who said that Germany and the ECB are on the same side, which elicited a major sigh of relief from euro bulls. She also said that Germany seeks a long-term solution to the sovereign debt crisis, during a trip to Canada. But Merkel is not the leader of Europe and thus her view does not necessarily represent the majority. Finnish officials have come out today touting the possibility of Greek exit, which seems at odds to Merkel's sentiment.

Where is the ECB?

Although the euro has been fairly resilient this week and the peripheral bond market has recovered well (Spanish 5-year bond yields are below their 100-day moving average at 5.4% and the 10-year yield continues to back away from 7% and is now below 6.5%), we are still missing a major piece of the jigsaw puzzle - the ECB has not yet clarified its position and is not yet acting as the lender of last resort. It said it won't offer Spain, Italy etc. more help until they sign up for bailouts and formal fiscal consolidation targets - i.e., no hand-outs until the ECB has a say in member states' national budgets. Merkel said on Thursday that she agrees with Draghi and the ECB, but Spain has yet to request a formal sovereign bailout (banking bailout aside) and seems less than willing to give away its budgetary sovereignty to Brussels without a fight. Thus, the more its bond yields fall the less likely Madrid is going to want to apply for a formal bailout and the less likely it is that the ECB will actually step in to sort this crisis out and take up the mantle of financial pillar for the currency bloc. Strange but true...

This could thwart a long-term euro rally and makes it sensitive to sell offs, added to that the technical signs suggest that this rally is fairly tentative. The FX market may be buying euro, but not in huge quantities hence the bulls don't seem to have the puff to get EURUSD above 1.2450 anytime soon now that it is increasingly unlikely that the Federal Reserve will embark on more QE at its September meeting.

The dollar changes its stripes

The other theme that the markets could toy with today is the dollar reacting well to good economic news. The dollar rallied on a broad-based basis on Tuesday after strong US retail sales for July. Then the dollar rose by 0.4% on a broad-based basis and was up 0.5% against the euro. So watch out for the University of Michigan confidence index for August, which is due at 1455 BST/ 0955 ET today. It is expected to decline to 72.2 from 72.33 - the lowest level since December 2011. But if we get an upward surprise in US consumer confidence the dollar could have a strong positive reaction and EURUSD may be the casualty.

The Aussie: too hot to handle

The Aussie has been a big mover to the downside after the Australian Treasury dismissed the idea of intervening in the markets to weaken AUDUSD (however, they are discussing it so the markets won't rule out the possibility of some intervention at some stage in the future). It dropped 100 pips on the announcement and has not been able to make up ground after rumours of some large Australian banks selling their domestic currency. Below 1.0460 opens the way for a move towards 1.0280 - where the 200 and 100-day smas converge, which should act as major support zone. For a shorter-term set up I would look for a recovery back towards 1.0460-70 before jumping on the back of a short as the short term MACD suggests that this pair is oversold for now. The fundamental back drop is less Aussie supportive than it has been of late due to 1, the FOMC likely to remain on hold rather than boost QE and 2, the fact that Australian officials are concerned about Aussie strength.

Data Watch:

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Source: Econoday and Forex.com

One to Watch: USDJPY

The Japanese government hinted on Friday there could be more stimulus to try and beat deflation. Although the government seems fairly convinced that the economy will grow nicely for the rest of this year and 2013, the government may establish a secondary budget to boost investment in new growth areas like green technology to ensure that the economy's momentum is maintained. These comments are fairly yen neutral, but the yen remains the worst performer this week out of the major currencies. The future movements of the yen are likely to be determined by the FOMC and US Treasury yields.

The chart below shows USDJPY and the spread between US and Japanese 10-year government bond yields. The spread has moved in the US's favour and this has been followed closely by the move higher in USDJPY. Thus, we need to watch this spread to try and garner where the USDJPY rate will move to in the medium term. Above 79.30 - the 200-day sma, could see back to 79.60- the top of the Ichimoku cloud, which is the start of a technical uptrend, and then towards 80.00 - a major resistance zone.

USDJPY and 10-year yield spread

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Source: Forex.com and Bloomberg

USDJPY: Daily chart

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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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