Kathleen Brooks, research director at Forex.com, takes a look at the events shaping the currency markets in the week ahead.

Has Europe’s sovereign crisis turned a corner?

This time last week the market was looking forward to Eurozone officials taking decisive steps towards creating a permanent solution to the sovereign debt crisis. However, two meetings of European Union (EU) officials passed with no resolutions agreed. In fact, the German finance minister Wolfgang Schauble said that the calm that has descended on the peripheral bond markets in recent weeks meant there was less urgency to make changes to the current European Financial Stability Facility (EFSF).

It seems likely that there will be no progress on a permanent solution until the EU council meeting scheduled for 24-25 March. Then officials may agree to an extension of the EFSF fund, which currently stands at €440 billion. The timing of this meeting is important since it comes just before a state election in Germany on 27 March. Only after this can the German Parliament debate proposals for a permanent bailout facility.

Even though it may seem like Europe’s debt problems have been pushed down the road, the market has given Europe the benefit of the doubt. The euro has extended its rally this week and looks fairly comfortable above 1.3500. Investment flows into the safety of German bunds has also fallen, which has pushed up bond yields. The spread between German and US two-year government debt has widened to its highest level since November 2009, which could fuel EUR/USD gains back up to 1.4000.

The single currency may have yield on its side, but the path to 1.4000 could be bumpy. There has been a shift in the discussion of Europe’s sovereign debt crisis away from bailouts and towards default in Greece’s case and bank sector nationalisation in Spain.

Reports that Germany was working on a plan to provide Greece with a loan to buy back its bonds in a restructuring that could apply haircuts to senior bond holders was swiftly denied. If this is true, it would suggest that the EU is taking the first steps towards fiscal unity, which flaunts the fiscal sovereignty rule in the European constitution. However, officials may not be willing to take such drastic action yet, even if it does sound like a sensible long-term solution to Greece’s problems. The cost to insure Greek debt for five years has fallen this week, suggesting that restructuring could bring some certainty to investors and actually reduce risk for investors holding Greek debt. If you know for certain that you could be subject to a haircut then you can price Greek debt accordingly.

Spain meanwhile is working on recapitalising its troubled Caja banks. The financial position of the 17 domestic lenders is precarious at best. They are scheduled to report all of their non-performing loans and property holdings by 31 January. This could cause market jitters, especially if their liabilities are larger than the approximately €50 billion the market is expecting.

A chilly fourth quarter for the UK

The strength of the UK’s economic recovery faces its most severe test on25 January when GDP data is released for the fourth quarter of 2010. Market analysts expect the quarterly growth rate to dip to 0.5 per cent from 0.7 per cent in the third quarter and a whopping 1.2 per cent in the second quarter. But the risks are to the downside.

The trade deficit increased over the quarter, which will hit growth; also economic data released so far has shown a divergence between different sectors of the UK economy. The manufacturing sector has come back with a bang, and the PMI manufacturing index reached a multi-year high of 58.3 in December. In itself, this is good news. However, the manufacturing sector is only a small portion of the UK’s economy, a far more important sector is consumption, and there the figures are looking grim.

Retail sales have been on a downward trajectory since October culminating in a dismal 0.8 per cent monthly decline in sales in December, a record drop. Although part of the decline was due to the coldest weather in a century hitting the UK, the hike in sales tax on January 1 suggests that retail sales will not pick up anytime soon. On another note, rising fuel and food costs also depressed retail sales at the end of 2010, which puts more pressure on the Bank of England. The minutes of the latest Bank of England meeting will be released on 26 January, which should give us some idea of where the debate is heading within the Monetary Policy Committee: to hike or not to hike?

As mentioned, there is a chance that expectations for the UK’s economic growth are overdone. If we get a weak GDP reading next week then we could see a sharp reversal in long sterling positions. We were wary about the sustainability of growth in the UK, and wrote in our first quarter 2011 outlook that we thought 1.6000 would be a tough resistance level for GBP/USD to break through; so far it looks that way.