It doesn't.
It's an economic choice. As more and more people are switching to the iPod touch/iPhone platform because of software features, sales of the classic iPod must have gone down considerably. Sales figures probably told them that fewer people bought the 160 GB version. So unifying those two models leads to economies of scale. Also, they probably can get the 120 GB drives cheaper. 160 GB is total overkill for most people anyway. This is the ultimate incarnation of the "classic" iPod anyway, it is near the end of its life. So there's not much of a point in keeping a high-end version with more storage now. Apple will cease production within a year and a 128 GB iPod touch will be released as successor, probably with next year's new autumn line-up. Flash prices will have gone down further by then, and the 128 GB touch will still be a slight upgrade on the current classic, capacity-wise (256 GB could still be too expensive for the mass market next year).
USB ports are suboptimal for that kind of thing. And the idea of a "docking" station is very, very unlike Apple. I'd rather see them taking the wireless route. But then, I am virtually sure we won't see a tablet announced on tuesday (or in the near futures).
I haven't seen 10" displays in 1280x768. But I've seen 9" displays. They are excruciatingly small for this resolution. Maybe not for you (and me, as I prefer slightly higher resolutions myself), but for a lot of people. I think Apple/Steve have made their point very clear with the Air: We're not going to see considerably smaller displays with OS X in its current form.