By Mike Jones, Currency Strategist, Markets, BNZ

The US Fed did the twist instead of setting sail on the QEIII, underpinning a modest rally in the USD this morning. This has knocked the NZD/USD 30-40 points lower. However, risk sentiment and the NZD continue to be propped up by hopes a resolution to the EU crisis is in the works.

The Federal Reserve decided to extend its Operation Twist programme this morning, in response to signs of slowing economic momentum. The USD and US bond yields headed a little higher in response, given some had been plumping for more aggressive Fed action (QEIII).

However, gains in the USD were held back somewhat by hopes European leaders may finally be getting serious on measures to combat the EU crisis. Investors were particularly encouraged by signs Germany may allow the EFSF/ESM to buy sovereign bonds. European equity markets eked out modest gains and our risk appetite index (scale 0-100%) ticked up to 57.2%, from 55.9%.

Looking ahead, there is some risk investors' high hopes for decisive action from European leaders are dashed at next week's EU Summit. This would undoubtedly knock back risk sentiment and dampen enthusiasm for the 'growth-sensitive' NZD. However, building expectations in the interim may prompt a NZD/USD test of 0.8050. Solid support is expected on any dips towards 0.7810.

The feature event of this week's local event calendar is this morning's Q1 NZ GDP (10:45am). BNZ economists are looking for a reasonable 0.6%q/q expansion. The market is straddling 0.4/0.5% while the RBNZ are looking for 0.4%. A disappointing number would weigh on the NZD, but reaction may be limited by the fact that a) the data are backward looking (we're almost in Q3!), and b) growth indicators for the second quarter are already looking strong - witness the recently encouraging retail, housing, PMI and PSI data.

Majors

Squinting your eyes through a bit of volatility, the major currencies are little changed from this time yesterday. The USD is mildly stronger.

Despite all the hype and expectation, this morning's FOMC policy decision proved to be something of a damp squib for markets. As expected, the Fed watered down its assessment of the US economy. Forecasts for 2012 GDP growth were lowered to 1.9-2.4% from 2.4-2.9% in April. Unemployment forecasts were revised up.

Nonetheless, the Fed disappointed hopes for additional asset purchases (QEIII), choosing instead to extend its Operation Twist programme as most expected. The Fed did say it was "prepared to take further action", suggesting additional easing is on the cards should US economic conditions continue to weaken.

Investors' disappointment at the lack of QEIII prompted some knee-jerk buying of the USD. But the Greenback's gains didn't last for long. After sliding � cent to 1.2650, the EUR/USD recovered all of its losses after German chancellor Merkel was seen as relaxing Germany's hard line stance on policy measures to address the EU crisis.

Suggestions from Merkel that the EFSF may be allowed to purchase sovereign bonds on the secondary market saw European peripheral yields decline across the board, bolstering EUR sentiment. The 10-year Spanish government bond yield fell back below the critical 7% level, to around 6.75%.

Markets are now hopeful that a banking union deal and an agreement on the ESM's use for sovereign debt will be announced at the EU Summit at the end of next week. No decisive action would take a heavy toll on the EUR. But as expectation continues to build in the interim, we could see the EUR/USD test 1.2750.