•  But China is the one actually raising rates: another surprise RRR hike - inflation is still an issue
  •  Market's shift back to the ECB's exit policy
  •  EURUSD may continue to rally, but watch for a resumption of sovereign debt fears
  •  Markets expect to see a solution to the sovereign debt problems in Europe - next week's ecofin meeting is important
  •  US inflation data ahead is key
  •  Watch out for JP Morgan's results

Yesterday's post-ECB press conference was worth waiting for. The market took Trichet's comments that the ECB had noted that inflation, which at 2.2 per cent in December is already at a two-year high, could rise further as a hawkish signal. In fact, Trichet signalled that the ECB will need to see the burden of proof from the economic data in the coming months before a rate rise. But although a rise is not imminent, we can't rule one out later this year.

All of a sudden we have shifted back to the pre-QE2 theme that dominated the forex markets prior to November: the ECB's exit strategy. The hawkish bias in the ECB is much stronger and more powerful than it is in the Fed, and this is driving euro strength. Although the pace of yesterday's mega- intra-day rally - EURUSD rose more than 2.5 per cent - is unlikely to be sustained, EURUSD could trade higher on the interest rate differential with the US moving in the euro's favour. So the ECB don't actually have to raise interest rates this year for the euro to trade well against the dollar, it just has to be closer to a rate hike than the Federal Reserve.

The next level in focus for EURUSD is 1.3500, but to gauge the strength of this rally and determine if there is potential for EURUSD to move back toward the 1.4200 highs, we would have to see a sustained improvement in the economic outlook in Europe and even more of a moderation in peripheral nations' bond spreads. So euro strength is the dominating theme for now, but it may not stay that way for long is sovereign debt woes come back to haunt the currency bloc.

A speech this morning by Germany's Bundesbank president Axel Weber didn't add anything else to the debate about the ECB's exit strategy. He said that German GDP could moderate and that inflation risks were moving to the upside, but he followed Trichet's line and said that interest rates remain appropriate. Earlier, French finance minister Christine Lagarde told reporters that EU officials would consider plans to extend the size and scope of the EFSF rescue fund. Next week the focus will shift toward the ecofin meeting and a credible long-term strategy to resolve the sovereign debt crisis. Part of the euro's gain this week has been due to the market giving Europe the benefit of the doubt that it can come together and sort out the peripheral debt mess, if it instead sees this rally in European assets as a reason to drag their heals then we could see a quick reversal in risk sentiment.

While Europe ponders if it can risk raising rates while the economic recovery is so uneven, China surprised the markets and hiked the reserve requirement ratio by 50 basis points effective 20 January. Combined with the Christmas Day rate hike, this reinforces China's determination to soak up liquidity and tame inflation. The rise in food prices is of particular concern to China since food makes up such a large part of their consumer price inflation index. Today's move suggests that inflation is continuing to climb in the emerging market powerhouse. China's official visit to the US next week will also be in focus. Any sign of an escalation in currency tensions between the two nations could hurt risky assets.

Stocks are taking a breather today after a strong run this week. But JP Morgan's results due out at 1200GMT (0700ET) could cause a flurry of excitement, so watch out. Oil and gold are also a touch lower after strong gains this week; partly this is due to a stabilisation in the dollar. The dollar index has fallen 2.5 per cent this week but seems to be bouncing off the 78.8 level.

In the UK strong producer prices were tempered by a fall in core producer output prices in November to 2.9 per cent, this is encouraging due to the UK's sticky inflation problem. The pound is fairly flat today after a strong week on the back of dollar weakness. Sterling is not the big story in FX markets at the moment, and is being dragged higher and lower based on where EURUSD is going.

Ahead the markets will focus on US inflation data and retail sales. A strong reading for retail sales would cheer the economy and could boost both risky assets, but watch out for inflation. If core inflation remains at 0.8 per cent for December as the market expects then the sceptre of more QE from the Fed will remain on the table, which could hinder any dollar strength.

Data watch:
12.00 GMT (0700 ET) US Geithner speaking
13.30 GMT (0830 ET) US CPI Last 0.1 M/M Exp 0.4 M/M 1.3 Y/Y
13.30 GMT (0830 ET) US Core CPI Last 0.1 M/M 0.8 Y/Y Exp 0.1 M/M 0.8 Y/Y
13.30 GMT (0830 ET) US Retail Sales Last 0.8 Exp 0.8
13.30 GMT (0830 ET) US Retail Sales ex Autos Last 1.2 Exp 0.7
13.30 GMT (0830 ET) US core retail sales Last 0.8 Exp 0.3
14.15 GMT (0915 ET) US Industrial Production Last 0.4 Exp 0.5
14.15 GMT (0915 ET) US Capacity Utilisation Last 75.2 Exp 75.6
14.55 GMT (0955 ET) US Michigan consumer sentiment Last 74.5 Exp 75.5
15.00 GMT (1000ET) US Business Inventories Last 0.7 Exp 0.7
17.45 GMT (1245ET) US Lacker (FOMC Non - voter) speaking on the economic outlook
18.15 GMT (1315 ET) US Rosengren (FOMC Non - voter) speaking

Best Regards,

Kathleen Brooks| Research Director UK EMEA | FOREX.com
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