Kathleen Brooks, research director at Forex.com, gives her outlook on the events and news shaping the currency markets.

Data released from China today showed that the Asian powerhouse continues to grow at a fierce pace. The economy picked up pace in the last three months of 2010, rising 9.8 per cent, up from 9.6 per cent in the third quarter. Growth was driven by a large expansion of retail sales, which expanded at a 19.1 per cent annual pace at the end of 2010, and industrial production. This illustrates the growing importance of consumption in China, where domestic demand is trying to catch up with exports and manufacturing as a key economic driver.

Encouragingly, the inflation rate dropped from 5.1 per cent to 4.6 per cent in December; however, inflation is still very high in China. Upward pressure on prices is coming mostly from food, which makes up the bulk of China’s CPI basket. While Beijing can’t control the rising cost of agricultural commodities it can hike interest rates, which would weigh on asset price inflation. Right now deposit rates in China are extremely low, making other investments in property etc more attractive. While the People’s Bank of China tends to hike rates sporadically (its last 25 basis point hike was on Christmas Day) the pressure is mounting for further tightening.

After digesting the good news, the market then started to contemplate the prospect of China slamming the breaks on growth too quickly. This has weighed on risky assets, specifically the Aussie dollar, which is back below parity. However, global stocks had their worst daily performance since November yesterday, and are due a bit of respite. European equity markets have started the day slightly higher, and we expect this bid tone to follow in the New York session.

After rallying on the back of the Chinese data and rate hike fears, the dollar is paring back its gains. 1.3500 is back in sight for EUR/USD (currently it is trading at 1.3490) and GBPUSD is also following with 1.6000 in sight. EUR/GBP is also moving higher on the back of stronger EUR/USD. The euro is still being driven by yield. The three-month euro swap rate has moved sharply higher since last week’s European Central Bank meeting, and is outpacing the USD three-month swap rate and the GBP rate. Sterling has less of a clear-cut driver, and GBP/USD performance is probably somewhat due to the strength in EUR/USD. However, next week’s Monetaru Policy Committee minutes from the Bank of England may bring the focus back to the UK and its sticky inflation problem. Any hawkish tone to the discussions at the Bank could see sterling experience a euro-like rally.

On another note, I was asked recently how to trade China. While my initial thought was to use the Aussie dollar as a proxy for China, its internal problems leave me wary. However, if we see a continuation of China and other Asian economies continuing to diversify their currency reserves out of the dollar, then the only place for them to go is the euro due to the size and depth of the Eurozone markets. This could lift the single currency even as it muddles through finding a solution to the sovereign debt crisis. This is just a thought, but worth keeping at the back of your mind when reading comments that the euro is bound to fail.

While thoughts at the start of the week centred on the prospect of a change to the European Financial Stability Facility rescue fund due to some high profile meetings of EU authorities, the meetings passed without a resolution. Headlines yesterday that Germany was drawing up plans for a Greek debt default were swiftly denied, but showed the potential future direction of the sovereign crisis for peripheral nations, especially those who accept a bailout. Overall, we end the week no closer to a resolution to Europe’s problems, but the markets remain fairly calm and are giving the Eurozone authorities the benefit of the doubt for now, and buying the euro on the back of its favourable yield differential relative the USD and GBP.

The calm that has descended din the markets is reflected in the gold price. It remains stuck in a range, but the bias is lower after the precious metal failed to make traction above $1,420 per ounce on three occasions. On the downside, support is noted at $1,335 - the November 2010 lows.