The euro took an additional hit on the back Spain's sovereign ratings downgrade. Chris discussed this systemic risk in his recent Pro Traders Club video, suggesting that the EMU mechanism is at risk with weaker links in Spain, Italy, Greece and Portugal. This will soften EUR tone in 09 if the market grabs hold of it. The early-year rally in risk appetite has clearly halted but governments have heeded warning signals and are progressing rapidly to prevent a further collapse in confidence. However, we are more concerned about the consistency of government measures rather than the speed at which they are responding. It does appear, especially in the UK and Eurozone, that improving credit availability is the new priority, as this is a necessary condition for re-igniting economic growth. In the US, the focus will be on the incoming administration's bailout package, which will also include elements to restore trust in the banking sector. The sharp selloff in financials towards the end of last week shows that it is also premature to call time on sector-based risk aversion. Even though deleveraging flows have slowed and may even be near a bottom, there are plenty of factors arising from both the banking sector and the real economy globally that have the potential to sharply limit or force an unwind in risk-seeking flows. Ahead this week the data calendar is very light in the US. President-elect Barack Obama will be inaugurated on Tuesday and a few housing indices, including MBA mortgage applications and the NAHB housing index, will be released throughout the week. Generally, there have been clear signs that credit conditions are on the mend with libor spreads narrowing and US commercial paper issuance picking up. There is risk abound and unseen, although we may see an "Obama Rally", USD and JPY strength remain the theme in the near term.

Spain has lost its AAA rating from the S&P as the agency downgraded the country's long term debt to AA+. This has been expected since the country was put on negative watch one week ago. Yet again this move underscores the divergence of performance within the Eurozone economies and the countries in question may be more inclined to pressure the ECB for more aggressive action on rates. Another key concern for the EUR is the amount of debt supply due to enter fixed income markets this year for stimulus purposes.ZEW will be important this week.

Risk aversion will remain the dominant market theme for the bulk of the first quarter. Today's reaction to UK plans for further banking sector bailouts, as well as changes to the Bank of England's powers (ability to purchase assets, albeit fully funded), suggests that investors remain extremely wary. UBS economists expect the USD and JPY (and to a lesser extent CHF) to outperform over the next three months as risk-averse investors continue to demand safe haven assets like US Treasuries. In addition, fiscal stimulus remains the key to stabilising the US economy, and rising bond issuance is attracting inflows further boosting the greenback.

This week is a little quieter as far as economic news is concerned. Following last week's 50bp cut from the ECB and Trichet's mixed promise that they had not signalled a base at 2%, we continue to expect an ECB in catch-up mode to be negative for EUR, both against the USD and on the crosses. On the JPY, while further risk aversion is likely to see JPY crosses lower, any sharp moves in USDJPY below 90 may prompt further warnings of official intervention.

Today's bank bailout plans and, more importantly Bank of England changes, were not taken well by GBP. On the BoE changes while any asset purchases are to be funded, market fears that this is step one towards the potential for quantitative easing are likely to see GBP remain under pressure for now. Elsewhere, an ECB in catch up mode should see EUR under pressure, with EURCHF, EURNOK and EURSEK likely to continue lower from their overbought levels at the end of last year.

Renewed concerns about the health of the global economy, subdued commodity prices and weaker global trade all point to commodity currencies underperforming again. Expect to see AUD and NZD to track the EUR lower against the USD over the next three months. Only beyond that will relative fundamentals (with the Australian economy remaining in good health) come into play.

Tags: Financial Crisis