Kathleen Brooks, research director at Gain Capital, gives her outlook on events shaping the currency market today.

After experiencing its best weekly performance in more than two years the euro is on the back-foot at the start of this week as the dollar recovers some composure after losing 2.5 per cent on a broad-based basis last week. The start of the week sees an important meeting of the Eurozone’s finance ministers, who are set to discuss changes to the European Financial Stability Facility (EFSF). These changes, first reported last week, include an increase to the size and scope of the fund. This would include giving the fund the power to directly purchase the debt of beleaguered members, a role which has fallen to the European Central Bank since the onset of the crisis last year. But this is something the bank seems keen to get rid of.

The market has been prepped that a final decision on a more permanent resolution to the sovereign debt problem will not be imminent and may not be agreed until 4 February at the meeting of Europe’s heads of state. However, a dearth of economic data due to a US public holiday means that any headlines coming out of the meeting will be held up for scrutiny by the market to determine how committed Europe’s finance leaders are towards finding a permanent solution to the crisis. It seems more and more likely that the only logical solution to the crisis will be closer economic and fiscal ties and a change to the original EU Lisbon Treaty that insisted on the fiscal sovereignty of nations and did not allow transfers from one member to support the financial position of another. Germany’s approval to these watershed changes is the lynchpin necessary for a long-term solution to work; it looks as if they will give their agreement, but only at the cost of tougher austerity measures for the debt –ridden periphery.

Traders need to watch the headlines coming out of today’s eco-fin meeting closely as this was one factor that drove the euro higher last week. Markets were cheered at the prospect of European leaders, at last, seemingly moving toward a unified long-term solution to the crisis. If the meetings this week fail to make headway then the markets could lose faith in the will of member nations to sort out the sovereign difficulties the currency bloc is facing and we could see a sharp reversal in direction for Eurozone assets, including a dive lower for the euro.

Elsewhere, the Aussie dollar is recovering some of Friday’s losses after China hiked the reserve requirement ratio for the first time this year. It is also benefitting from a retreat in floodwaters in Queensland. Interestingly, the latest data from the CFTC show that traders still remain fairly long the Aussie dollar, although there was a reduction in positions last week. This is positive and suggests that the Aussie could continue its grind higher and leaves another shot at parity a realistic scenario for the coming weeks.
 
The Canadian dollar remains fairly flat before tomorrow’s Bank of Canada interest rate announcement. The market expects the Bank to leave rates on hold at 1 per cent, even though economic data has been ticking up recently, due to the uncertain global economic environment. Stock markets have had a fairly weak start, and even though oil company BP jumped above 500p per share on news of a deal with Russian state-controlled oil giant Rosneft, this hasn’t pushed up the FTSE 100. This is partly due to the fall in BP’s market capitalization as a result of the Macondo oil spill, which has reduced its influence on the index. It is currently 6.14 per cent of the index, this compares with HSBC, which makes up nearly 8 per cent.

Commodities are trading lower in line with a stronger dollar this morning and gold has also fallen 0.5 per cent during the European session.

It’s a quiet data week in the US, which could leave the UK and Europe centre stage. Spain has cancelled an auction for 20 January, instead using a syndicated sale (private bond sale). But Germany, Netherlands and Belgium will all tap the market for short-term debt later this week. The UK has a hefty schedule of economic data releases. CPI is released tomorrow and unemployment data on Wednesday. Also watch out for the start of China’s president Hu Jintao’s visit to the US that begins tomorrow.