JPY and GBP to slip further

Market gyrations were relatively limited overnight, with a rise in the VIX fear gauge and rise in Chinese equities the most notable market moves overnight. US data was mixed, with enthusiasm over a solid gain in December durable goods orders tempered by a drop in pending home sales. Notably the Baltic Dry Index has extended its decline over recent days, suggesting that the risk rally is losing some steam.

Nonetheless, core debt yields continue to test important psychological levels, with the 2% barrier in sight for 10 year US Treasuries. Data and events today include a US consumer confidence, for which we expect a slight decline in January, and various European Central Bank speakers. Additionally, the ECB’s main refinancing operation (MRO) will be scrutinised to determine bank’s health following last week’s LTRO payback. Overall, direction looks limited ahead of this week’s Fed FOMC decision and US jobs report.

The JPY’s drop has proven to be relentless. Despite being blamed for instigating a currency war Japanese officials are showing little let up in their push for JPY weakness. Although there has been some widening in the US Treasury and German bunds yield advantage over Japanese JGBs it does not fully account for the sharp JPY move. Interestingly speculative JPY short positions have actually lessened, implying that the drop in the JPY is attributable to other investor classes.

Additionally Japan has registered net portfolio inflows over recent weeks and so cannot explain the JPY’s drop. One factor that is weighing on the JPY is the improvement in risk appetite; USD/JPY is the most correlated currency with our risk barometer over the past 3 months. As risk and yield appetite has picked up JPY has effectively regained its mantle as funding currency. USD/JPY will face some tough resistance levels from around the 91.48 level, but so far the currency pair has made short work of breaking through resistance.

In one respect GBP’s drop against the USD and EUR reflects a reversal of safe haven flows similar to JPY. Notably however, GBP has not been correlated with the JPY. Its decline is more associated with renewed UK economic worries and in turn expectations of further Bank of England asset purchases, especially under the helm of a new governor. Moreover, speculation of a credit ratings downgrade has not been helpful to GBP. The net result is a reduction in speculative interest and further selling pressure.

Fortunately for the UK economy a weaker currency is no bad thing unless it provokes growing inflationary pressures. Given the dovish noises from incoming BoE Governor Carney, it looks as though there is little concern on this front. Manufacturing confidence data at the end of this week is unlikely to dispel economic concerns, leaving GBP vulnerable to further slippage.

ECB In Focus

The highlight today is the European Central Bank (ECB) council meeting. Markets have priced in a hawkish stance from the ECB; Euro rates have edged higher whilst EUR/USD has strengthened. The ECB is likely to highlight worries about price developments today paving way for a hike in H2 2011. Watch for any shift in the balance of risks statement in the press conference and upward revisions to inflation and growth forecasts. In terms of liquidity operations the full allotment procedures at the Main Refinancing Operations (MRO) are likely to be extended for another three months.

EUR risks are asymmetric and whilst the currency remains a buy on dips (with technical indicators pointing to a move to 1.4000) the bigger risk is if the ECB does not live up to the hawkish market expectations which could hit EUR given long positioning overhang. Other than this, risk aversion remains elevated according to my barometer, supporting JPY and CHF. US numbers remain upbeat as seen in the ADP private sector jobs report yesterday, which will likely lead to an upward revision to non-farm payrolls forecasts in February (currency consensus 195k). However, the USD impact of positive data is limited against the background of a relatively dovish Fed stance.

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