Tuesday's trading session has been dominated by risk aversion with commodity currencies weaker against their major counterparts, and the Japanese yen and US dollar stronger not only versus commodity currencies but also against the euro and pound.

What has caused this shift in risk sentiment over the previous few sessions?

Starts with Bernanke's Testimony

width=289We can trace the genesis of the recent risk aversion to the testimony Bernanke delivered to Congress last Wednesday as he undercut expectations for further quantitative easing by not referring to any such steps in the near-term. That caused a large reaction mainly in the gold markets but also stalled out the rally we had seen building in equities.

The assumption by larger financial institutions that QE3 of about $500 billion of mortgage backed securities was a given has been weakened, and without the morphine administered to the markets from more loose monetary policy (money printing) it sets the stage for a reassessment of recent rallies in risk assets.

China Sets Weaker Growth Target

With the market already hesitant following Bernanke hinting at taking away the easy money punch bowl, the market was caught flat-footed by the Chinese announcement that it would target a GDP growth rate of 7.5% in 2012.

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Looking at the current pace of China's GDP that would imply further deceleration which would put downward pressure on commodity prices and therefore weaken commodity currencies like the Australian dollar, New Zealand dollar, and Canadian dollar.

Chinese authorities will also try to accelerate their efforts to re-balance the economy away from an export and investment oriented one to an economy that is more driven by domestic consumption.

While that could mean an increase in imports by Chinese consumers - and more demand for finished goods - a move away from an export oriented economy would likely weaken  the demand from Chinese manufacturers for key commodities like iron ore and coal which have been instrumental to the performance of the Australian economy for instance.

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We can see the concern around global growth as a result of China via copper prices which seem to be attempting a double top pattern. If we have a break of the neckline in the subsequent days that would be a sign that the global economy is weak and would undermine the strategy of buying higher-yielding currencies and riskier assets.

Euro-zone Growth Jitters

On the heels of Bernanke and China, market participants also had to digest news that the euro-zone services data undershot the preliminary reading, showing that besides for Germany, the other large economies in the Euro-zone are struggling.

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While France just made the 50 level separating expansion from contraction Italy and Spain fell further into contraction in this key sector. That increases the concern that euro zone growth will falter in the months to come and opens up the specter of the ECB meeting to lower interest rates sometime in the next few months which should pressure the euro

For more on euro zone factors following the LTRO 2 operation last week see:

Can Greek PSI Deal Unravel?

On top of Bernanke, China, and Euro-zone growth jitters we also have the possibility that the private sector involvement deal reached with Greek creditors could fall apart if there isn't enough voluntary participation. The second Greek bailout is conditional on the debt swap going through successfully, with a deadline for private creditors to come forward of March 8.

So far about 20% of the creditors have come forward and agreed to the debt swap.

From Bloomberg: The private investors that so far declared their participation in Greece's debt restructuring hold about 20 percent of the bonds involved in a swap required for an international bailout.

A failure here, and a messy default, could cost up to 1 trillion according to the IIF which also caused angst in financial markets.

From FT: Separately, the body representing a substantial number of Athens' private sector government bond holders warned that the cost of a Greek disorderly default and exit from the single currency could rise to €1tn.

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Risk Aversion Driven More by Global Growth Concerns or PSI Worries?

Is it the fear of a messy default by Greece or is it global growth concerns that have been the predominant reason for the shift in risk sentiment?

For that we want to look at the euro against a commodity currency like the Australian dollar. Looking at this pair we see that in fact the EUR/AUD has rallied in today's session which suggests that global growth concerns are dominating concerns about the unraveling of the PSI deal.

What Can Turn Around Risk Aversion - Upcoming Risk Events

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The momentum for risk aversion certainly picked up as the S&P 500 cracked an important support level 1351 and we saw the yen gaining sharply against commodity currencies showing its back in favor for those seeking safer havens and those unwinding Asian-Pacific carry trade.

What we want to watch for in regards to a flip back to a more risk-on mode or a continuation of risk aversion would be the Thursday deadline for the PSI and seeing if the Greek's can get the participation needed.

If it can secure the needed majority - 75% by its standard - and its enough to allow the deal to go through and allow an orderly default instead of a disorderly default that could help risk sentiment.

The second key event to watch is Friday's US non-farm payroll data as it will be a key test for the recent momentum of the US economy. If non-farm payroll surprise to the upside a growing US economy should help to bolster risk sentiment while a miss, especially a big one that puts job growth near 150K or so would likely create the conditions for further weakness with the risk assets, equities, and higher yielding currencies suffering.

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Nick Nasad is a macro economist, market analyst, and educator; and one of the main contributors to  FXTimes - provider of Forex News, Analysis, Education, Videos, Charts, and other trading resources.

Information and opinions contained in this report are for educational purposes only and do not constitute an investment advice. While the information contained herein was obtained from sources believed to be reliable, author does not guarantee its accuracy or completeness. FXTimes will not accept liability for any loss of profit or damage which may arise directly, indirectly or consequently from use of or reliance on the trading set-ups or any accompanying chart analysis.