The NZD/USD soared to four month highs above 0.8240 on Friday, to finish the week up 2.3%.

Worsening sentiment towards the USD was the chief driver of last week's NZD/USD gains. The promise of extra liquidity from the US Federal Reserve on Thursday saw the USD suffer, as US interest rates tumbled.

Last week's RBNZ decision to hold rates at 2.5% was relatively unexciting. However, the lack of any attempt to talk the currency lower was interpreted as a 'green light' to keep buying the NZD. As a result, the NZD/USD continued on its path higher in the wake of the statement.

It's worth noting, NZ-US interest rate differentials widened last week, conferring 'fundamental' support on the NZD/USD. Sliding US interest rates (largely thanks to the dovish FOMC) saw NZ-US 3-year swap differentials rise from 226bps to 236bps over the week.

Near-term direction for the NZD depends on which side prevails in the current tug-of-war between domestic negatives and global positives. For now, the positive global drivers of buoyant risk appetite and a weaker USD have the upper hand.

How much farther the NZD/USD rises in the short-term therefore depends on how the global backdrop evolves. In this regard, we see scope for the recent run of less negative European news to continue (watch for a Greek PSI deal in the next few days), and further mild USD weakness. Should this pan out, the NZD/USD could climb as high as 0.8370 or even 0.8570 before we see any sort of correction.

Regular readers will be aware that we've have been calling a lower NZD/USD through Q1. This view was predicated on some deterioration in global risk appetite and the NZ economy stumbling sideways. So far, we've been right on the latter point but wrong on the first. We still like the idea of a modest downward correction in the NZD/USD in coming weeks, but we'll likely scale back the extent of this dip as we update our forecasts.

For today, we'll be looking out for the December BNZ PSI to see if can sustain November's sizable result of 56.6. But the bigger event risk around the currency is the prospect of agreement on Greece's private sector debt swap deal (seen as critical for Greece to avoid default). A positive outcome would underpin the EUR/USD and "risk-sensitive" currencies like the NZD.

Majors

On a trade-weighted basis, the USD fell almost 2% last week as the doves took roost at the US FOMC. On Friday, the USD continued to slide following disappointing US GDP data.

US GDP grew 2.8% (annualised) in Q4, the quickest pace of growth since Q2 2010, but still shy of the 3.0% analysts had forecast. Moreover, the details were worrying. A build-up in inventories contributed much of Q4's growth, while consumption was noticeably weaker than expected (2.0% vs. 2.4% expected). Speculation the Fed will be called on for more stimulus (QEIII) knocked US bond yields lower, weighing on the USD.

At the same time, market chatter that a deal on Greece's PSI was (finally) close to being announced underpinned the EUR. EU Commissioner Rehn fanned the optimism when he stated a deal could be expected sometime over the weekend (nope, still waiting). From around 1.3100, the EUR/USD climbed to almost 1.3230 as the speculative community further unwound EUR shorts. Ratings agency Fitch's downgrade of 5 European sovereigns acted to cap the EUR's gains somewhat.

The perky EUR, combined with the broadly weaker USD, saw all of the major currencies post gains on Friday. Illustrative of the worsening fortunes of the USD, USD/JPY tumbled from 77.50 to around 76.70.

Looking ahead, we see scope for USD weakness to continue this week. Market speculation (hope?) the Fed will deliver QEIII may continue to undermine the USD. Meanwhile, a positive outcome on the Greek PSI deal could provide more fuel to the short-covering EUR rally. Friday's IMM data showed the speculative community added to already "extreme" EUR short positions last week, suggesting positioning unwinding could provide more support to the EUR.

European policy makers will be doing their best to boost market confidence during tonight's EU Summit. Expect the EU fiscal compact to be finalised and the ESM treaty to be endorsed. We'll also be keeping an eye on the newswires for confirmation the Greek debt swap deal has been finalised. This could come at any time.

Data-wise, Wednesday's Chinese PMI and US ISM manufacturing (Wed night) and non-farm payrolls (Friday) figures will be the most closely watched this week. Support on the USD index is some distance away at 78.00. Resistance is eyed on bounces towards 79.50.

Fixed Interest

NZ yields inched down a little on Friday, and the DMO auction attracted solid demand.

Friday was relatively quiet, with NZ swap yields closing down a fraction, with 2-year at 2.80%. The short-end of the curve continues to price a slight chance of a 25bps rate cut from the RBNZ in the year ahead (30% chance by mid year). Rather, we see the RBNZ on hold for most of the year ahead.

Bond yields closed down 3-4bps after a solid DMO auction of 100m of 21s. The yield on 21s closed at 3.91%, around 10bps and 200bp respectively above AU and US equivalents. This is close to the top of their recent ranges, and suggests NZ long yields have room to fall relative to their off-shore counterparts. However, it does appear the market is already long NZ bonds, limiting further upside (declines in yield).

Overnight on Friday, US 10-year yields slipped from 1.94% to 1.89%, the bottom of recent ranges. This occurred after the low-side print on US Q4 GDP (2.8% vs. 3.0% expected).

Rating agency, Fitch, downgraded Spain and Italy and placed Ireland on negative watch. The ratings however are now only in line with, or better than, S&P equivalent ratings. The market showed little reaction. In fact Italian and Spanish yields continue to drift lower. Italian 10-year yields are now down at 5.90% (from recent highs above 7.20%). The ECB's 3-year loan facility to banks seems to be soothing nerves, and easing pressures on banks to sell sovereign bonds. Reduction in selling pressure is seeing a notable fall in sovereign financing costs. The week ahead will bring several more data points in this regard, with Italian, French and German bond auctions.

Locally, this week's data is mostly of 2nd tier importance for fixed interest markets. Today's Performance of Services Index would do very well to hold onto last months surge higher to 56.6, some way above the equivalent manufacturing index at 51.9. There is a slew of PMI data from China, Europe and US, from mid week. These will likely be the more significant drivers of markets this week, along with ongoing developments in Europe. Solid PMI releases should see long yields globally move up, dragging NZ equivalents higher, and curves steeper.