The tensions in the Middle East, specifically in Libya sent Brent crude soaring above $104 per barrel at the start of the European session. Libya is Africa's most oil-rich state so political turmoil there is spooking commodity markets. But it also has an impact on FX markets. Although commodity currencies such as the Aussie and the Kiwi dollars are struggling to gain traction today on the back of risk aversion, the euro and the pound remain supported versus the dollar. This is because rising oil prices put upward pressure on inflation in these economies (where the central banks monitor headline inflation pressures, in contrast the Federal Reserve looks at more moderate core prices), which boosts interest rate expectations and government bond yields. Due to the FX market's sensitivity to interest rates, the pound and the euro remain supported as long as there is a chance that interest rates may rise in the near future.

Right now the ECB and the Bank of England look like they are the closest to raising rates, this compares with the Federal Reserve, who has pledged to keep policy lose while job creation in the US remains weak. Thus, the spread of the political turmoil in the Middle East is not boosting safe haven flows to the dollar, and the dollar index - the greenback versus its largest trading partners - has remained fairly lacklustre during the Middle Eastern protests as markets instead focus on inflation and interest rates when trading FX.

There was some good news out of Germany's economy. The IFO index, which measurers industrial and business confidence rose to a record high in February. The business climate index rose to 111.20 from 110.3 in January. This was the 10th consecutive increase in the IFO, which adds to evidence that Europe is experiencing an uneven recovery with Germany powering ahead while the peripheral economies flounder, for example Portugal 's economy contracted in Q4 2010. The PMI surveys for both the manufacturing and services sector were also stronger in February, with the composite survey rising to 58.4 from 57.0, the highest level since 2006. The strong economic data from the eurozone caused the single currency to spike, but it soon pared some gains and is virtually flat versus the dollar.

A strong Germany could ease tensions surrounding the sovereign debt crisis, as it reinforces that the currency bloc has the financial firepower to ward off a crisis. However, a crushing defeat for Chancellor Angela Merkel's party at the weekend during state elections could put the brakes on Germany's willingness to assist its neighbours. Merkel's party lost control of Hamburg, Germany's richest state and Merkel's birth place. German authorities have a difficult balancing act in the coming weeks: it has to placate voters at home and show that it isn't going to support Europe's less financially conservative nations unconditionally, but it also needs to show continued support to the peripheral nations to placate the financial markets or else face a rout on peripheral sovereign credit and the euro. After all, Germany is the largest contributor to the EFSF rescue fund. There are further state elections on March 27, which will be watched closely by the markets.

Elsewhere, the G20 has had little impact on markets. Although it is encouraging that the G20 meeting discussed in detail the necessity for global economic re-balancing and looked at the steps necessary toward achieving it, the lack of concrete performance metrics to measure how the re-balancing effort is getting on suggests that it will be a long, slow process. This is reflected in the FX markets, which have all but ignored the outcome of the G20. Instead currencies are continuing to move on inflation and interest rate expectations, hence why EURUSD has rallied to above 1.3600 and GBPUSD is above 1.6200.

Ahead today may be fairly quiet due to Presidents Day in the US
Data Watch:
Germany 17:00 GMT (1200 ET) ECB's Stark Speaks

Best Regards,
Kathleen Brooks| Research Director UK EMEA |
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