Will this be third time lucky for the Euro?

By Kathleen Brooks, Research Director Forex.com

There has been some fall-out from the news, the Austrian government may need to inject EUR1bn into one of its domestic banks who wrote large amounts of insurance on Greek debt and now needs to pay up. This all happened after London had headed home for the weekend, but expectations that CDS's had been triggered were enough to cause the euro to fall for the second straight week. Will it be third time unlucky for the euro this week?

We shall have to wait and see. A lot will depend on the FOMC meeting. Bernanke and co. are unlikely to change policy or announce anything new, however we need to hear whether Bernanke is slightly more optimistic on the outlook for the economy post February's payrolls data and the upward revision to January's number. A more optimistic Ben and we could see a broader based gain in the dollar. Although USDJPY has been flying, EURUSD and AUDUSD have been more nuanced pairs to trade (that's a fairly posh way of saying they have been stuck in a range). The markets have been much more attentive to the Fed of late, so any signs that further policy support is not on the table could be enough to trigger a wider bout of dollar strength.

But the Fed isn't the only thing that could affect EURUSD and AUDUSD in the coming weeks. Taking EURUSD first, China this weekend announced that in February it had recorded its largest trade deficit since the late 80s. This number may have been affected by the Lunar New Year celebrations, but it also suggests that Chinese exports are a casualty of the Eurozone sovereign debt crisis. This impacts the euro since it reduces Beijing's currency reserves and the need for dollar diversification into the single currency, which was considered a major pillar of support to the euro and helped it to recover from its 2010 1.18 low.

Thus, in the short-term China's deficits matter for the euro as it weakens the "floor" to protect the currency if we get some adverse sovereign news or an extremely happy Bernanke next week. This makes a deeper drop below 1.30 a distinct possibility over the coming weeks.

China economic direction weighs on Australian dollar

The deficit also impacts the Aussie as a fall in activity in Beijing directly hurts Australia's trade balance and thus economic growth trajectory. This could seriously hinder AUDUSD's attempts at 1.10 and above in the medium-term. Also, a slowing China may make real money less willing to commit to the Aussie because of the domestic economy's ties to the Asian powerhouse, thus watch where the euro is headed for some direction in the Aussie.

But this is the worst case scenario for the Aussie. The other side of the coin is that China ditches attempts to revert to a more domestically-fuelled economy and instead loosens monetary policy and allows the yuan to weaken even further this year to try and give exports another boost. This is Aussie positive, another positive is that power changes hands in Beijing in early 2013, and the authorities don't want to rock the boat during this period as it has traditionally caused social volatility. Thus we continue to believe that a revaluation of the renminbi is not on the cards for the medium-term and the authorities may be willing to protect export growth with government stimulus, which may benefit the AUD vs. The dollar.

Interestingly, the dollar may be strong against the other majors but it is losing out to the CAD and the Mexican Peso. These two currencies are considered dollar proxies and they have oil, hence their stars' are in the ascendency for now.

Europe is still the major macro factor weighing on asset markets right now; however there are secondary symptoms (such as China's trade deficit) that could also start to impact the FX market. Right now we are in wait and see mode, but the gradual weakening of the euro and the stickiness of the major stock indices around some major levels are setting off alarm bells in my head. If levels like 13,000 in the Dow aren't convincingly broken soon then it may suggest that things could head south from here as the bulls in the crowd start to lose their nerve giving the bears the opportunity to gain the upper hand.

But of course the Fed could throw a curve ball this week. Right now that curve ball is a less optimistic FOMC who is taking Friday's payrolls with a pinch of salt. Any sign that more stimulus could be forthcoming could weaken the dollar, gives stocks a kick south and help gold as people worry about loose monetary policy globally and the inflation impact.