Kathleen Brooks, research director at Forex.com, gives its forecast for the currency market.

Egypt turmoil sparks safe haven buying

Political protests in Cairo and elsewhere in Egypt escalated into the end of the week, as the government called in the army to assist police and imposed a nationwide curfew. The protesters are demanding Pres. Mubarak step down and withdraw from elections in the autumn and guarantee free and fair elections. So far, Mubarak has responded in his standard fashion, sending in riot police with truncheons. Inspired by events in Tunisia, and with growing momentum behind them, the protesters seem unlikely to yield even in the face of violent government repression. This is a drama that will continue to play out in the days and weeks ahead, but we would anticipate the eventual downfall of Mubarak’s regime.

Global financial markets responded rather late on Friday with a sell-off in risky assets, with major global stock indexes dropping around 1.5 per cent and investors buying the 'safety' of US Treasuries, gold and currencies like the USD, CHF, and JPY. We are a bit surprised by the spike in risk aversion as the Egyptian economy is quite small and events there seem unlikely to disrupt the broader global recovery. More likely, investors fear the risk of uprisings spreading to other countries in the Mid-East and more significant regional turmoil. Still, we will keep an open mind as to the impact on overall risk appetite, but we would not be surprised to see markets calm down in relatively short order. We would also note that the risk sell-off came on the second to last trading day of the month, with stop loss-driven price action widely reported, suggesting positioning and liquidity played a major role.

With that noted, the technical picture for EUR/USD suggests ample potential for reversal, with a prominent bearish engulfing line on daily candlesticks, a doji on the weekly candles, and a potential close back inside the daily Ichimoku cloud if below 1.3626 at the NY close. EUR/USD gains were effectively contained by the 61.8% retracement of the 1.4280-1.2865 decline at 1.3741, providing additional support for a near-term top. Weakness below the 1.3500/50 prior range tops will likely signal a deeper correction.

A chilly start for the UK

Even though it was suspected that growth would slow in the fourth quarter of 2010 the 0.5 per cent contraction in the UK economy was a shock to the markets. Although some of the decline was exaggerated by the bad weather in December, the underlying growth story is also worryingly weak. It was assumed that consumption would receive a boost at the end of last year before the VAT hike on January 1, but this did not happen and activity in the services sector, which makes up the bulk of growth in the UK, was negative.

While the government has pledged to stay firm to its fiscal consolidation plans saying that it won’t be driven off course by the snow, there are growing calls for a plan B. If growth can recover to even a modest pace of expansion then the government may be able to continue with its spending cuts, however the UK is only one more negative quarter away from being back in a technical recession. The spending cuts haven’t started in earnest yet, and unemployment is set to rise as public sector jobs are slashed. This will keep activity depressed for the medium-term, and weigh on sterling in our view. As we mentioned in our quarterly update, we believe that 1.6000 is the high in GBP/USD for now.

The pound has had a volatile week. After falling more than 1.5 per cent after the GDP data, it recovered its poise, but is set to close slightly lower on the week. The reason for sterling’s rebound was the minutes from the Bank of England’s meeting, which showed two members voting for a rate hike after Martin Weale joined ranks with the hawkish Andrew Sentance. However, the Monetary Policy Committee did not know about the contraction in growth when they met earlier in January. So even though the Committee discussed whether or not to hike rates, but decided it would give the wrong signal to the markets back in January, the next meeting on 10 February will be more interesting. The bank needs to plug growth gaps caused by the fiscal consolidation and they might have to act sooner than most people thought.

Spanish steps to sorting out the Caja mess

There were some small but important developments in Spain‘s fiscal position last week. Firstly, the finance minister announced the government’s plans to help the troubled domestic banks, the Caja’s, that are crippled under the weight of bad real estate and developer loans. The government is imposing an 8 per cent minimum core capital ratio for these lenders as a tonic for the banks’ balance sheets. For the vast majority this will require another round of financing, and the government is drawing up plans for these banks to list on the stock exchange. The government’s desire is that most of this fundraising can be provided by the private sector. However, for the most troubled lenders private investment may be hard to find so the government will provide any capital gaps. While this could hurt the Spain’s public finances in the short-term the long-term benefit of stabilizing the banking sector is vital for the Iberian nation to get over this crisis.

Secondly, on Friday the Spanish government agreed to overhaul the pensions system. The retirement age will rise to 67 from 65 and the government will also increase the number of working years used to calculate pension benefits to 25 from the current 15. The law still has to go through parliament, so it may be subject to some small changes, but it highlights the Spanish government’s determination to rein in spending. This is also a first step toward improving labor market competitiveness although it has much further to go.

Steps already taken to rein in the deficit are starting to show some fruit, it was revealed last week. The government announced a drop in the central government deficit from 9.4 per cent of GDP in 2009 to 5.1 per cent in 2010; however the fall in the general government deficit, which includes local and municipal debts, slowed at a less impressive rate of 9.2 per cent last year from 11.2 per cent in 2009. So local government debts are not improving as fast as the central government’s, and news that the unemployment rate rose above 20 per cent in the last three months of 2010 won’t help the fiscal position of Spain’s local authorities as tax take falls. This keeps the pressure on Spain even though austerity efforts so far are a first step on the path to a more sustainable financial position. Spain’s next auction of three-year bonds is in early February.

RBA likely to hold on rates, Flood tax spurs debate

On Tuesday February 1, the Reserve Bank of Australia (RBA) meets to decide on interest rates. We agree with the market consensus that the bank will keep rates on hold at 4.75 per cent as Tuesday’s price data showed a slowing of inflation. Fourth quarter CPI slowed to 0.4 per cent from the prior 0.7 per cent quarter-on-quarter and saw a year-on-year decline to 2.7 per cent from 2.8 per cent. Additionally, the market is still assessing the impact of the floods on the health of the economy.

The Australian government announced on Thursday a special flood levy to help rebuild infrastructure in the aftermath of the Queensland disaster. The 12-month tax, which would become effective on July 1, will charge 0.5 per cent to those earning between AU$50,000-AU$100,000 while those earning more than AU$100,000 will see a 1 per cent hike in taxes. The one-time flood levy is expected to generate around AU$1.8 billion towards the reconstruction plan which is estimated to cost about AU$5.6 billion.

RBA board member Warwick McKibbin spoke out against the levy saying that the tax increase on households will unnecessarily impede consumer spending. He went on to say that borrowing is a far better strategy noting, 'This is a classic example of where governments should borrow. We have room to run deficits in the short term.' Given the fact that the floods are expected to negatively impact exports, a drag on personal consumption is likely to result in even lower growth expectations and may keep the RBA on hold for longer than anticipated.

The implications of short term fiscal and monetary policy as well as the recent movement lower in commodity prices are putting downward pressure on AUD. Technically, the pair has completed a bullish five-wave impulse which began in early June and is now in a corrective pattern. This suggests further downside potential in the near term before a continuation higher. Key support to the downside is the 100-day sma, currently around 0.9850 and then the 61.8 per cent retracement of the rally from about 0.9535 to 1.0255 which comes in around 0.9805 – also the 2011 lows. A break below these levels may see a deeper correction towards the 0.9550 December lows. The key resistance to the upside remains 1.0000. While the pair tested above parity briefly, it has been unable to sustain above. A daily close above parity is likely to see further upside towards 1.01 initially and then to 1.02 next.

Minimal impact from Japanese sovereign debt downgrade

On Thursday, Japan’s long-term sovereign debt rating was downgraded one notch to AA- by S&P. The knee jerk reaction saw USD/JPY boosted from recent 82.00 range lows to session highs around 83.20. Since then, the yen has strengthened back towards pre-downgrade levels around the 82.00 figure. This shouldn’t come as much of a surprise since ratings downgrades have historically had minimal impact on USD/JPY and JGBs. Eight ratings downgrades in the past twelve years have resulted in only modest daily losses for the yen relative to the buck while the two notch Moody’s downgrade in 2002 had almost no impact on long term Japanese interest rates. In sharp contrast, downgrades to sovereign debt ratings in the Euro-zone periphery have seen substantial fluctuations in EUR denominated currencies and domestic interest rates.

The basis behind such divergent reactions stems from the relative percentages of foreign domestic debt holdings. Economies with larger percentages of external domestic debt holdings are substantially more vulnerable to ratings downgrades while those with lower percentages are less impacted. Considering foreign holdings of Japanese government bonds are only about 5 per cent of the total, there are not likely to be any near to medium term reverberations in the Japanese bond or yen market. However, the current rate of debt acceleration is unsustainable in the long run – the International Monetary Fund’s latest report on Japan projected the ‘public debt-to-revenue ratio’ to rise to 482 per cent by 2015. It's clear that shifts in fiscal policy will be necessary to avoid longer term economic deterioration. The longer it takes before such policy shifts are implemented, however, the more significant the following question becomes: 'Can an ever dwindling sub-65 Japanese population of the future absorb the rapidly accumulating debt burdens of today?'