Risk appetite and the yen

Risk appetite has had a few wobbles this week but sentiment improved overnight with Asian stocks pushing higher in addition to oil prices. The JPY has duly weakened. While the market accepted the first downgrading of the Japanese economic outlook by the country's government without question, it was a reminder of the economic difficulties that have been created as a result of the Mar 11 natural disaster and resultant nuclear threat.

The BoJ's very easy policy stance is poles apart from most other major central banks that have either started to tighten policy or are contemplating when to do so. As long as risk appetite holds, it is reasonable to expect that Japanese investors will increasingly look off-shore for higher nominal yields. On this basis, further yen weakness across the board looks likely. Resistance for USD/JPY at 84.60.

GBP - economic reality hits

Yesterday's softer than expected UK CPI data (4.0% y/y) was the death knell to remaining calls that the BoE would hike interest rates in May. The number followed a very weak reading on the retail sector from the BRC and was accompanied by a drop in imports in the Feb trade report.

Not only do these data paint a picture of weakening demand but it is noteworthy that these releases refer to the period ahead of the implementation of the April austerity measures. Insofar as the April austerity will reach almost all sectors of the economy, it is likely that indicators of confidence and demand in the UK will get worse before they improve.

Today's the market is expecting a modest drop in the UK March claimants count but the ILO unemployment rate is expected to remain at its post financial crisis high (8%), suggesting little support for the pound. We expect most of the MPC will prefer to wait and see the impact of the austerity on the real economy before hiking rates. We foresee no rate hike from the BoE until Nov. On this view we continue to see GBP vulnerable vs. the EUR. Resistance at EUR/GBP0.8920/40.

EUR/USD

The market has been raising further its expectations with respect to ECB rate hikes this year. Coincidentally, China's reassurances that it will continue to buy Spanish debt appears to have endorsed the prevailing nonchalance in the FX market with respect to the peripheral crisis. With the peripheral crisis still having very little influence on EUR/USD, it seems likely that yield spreads will remain the dominant influence for the time being.

The imminent end of QE2 does raise the question of whether the US yields will rise once the Fed stops vacuuming up supply. However, we take the view that since the start of QE2 did not have a significant impact on yields nor should its demise. That said US yields can still rise on the back of other factors.

Note, however, that if yields were to react to the IMF's criticism over the country's failure to deliver a 'credible strategy' to stabilise its debt mountain or to the inevitable heated discussions between lawmakers as the $14,300 bln debt ceiling is re-negotiations this spring, this may not be USD positive. We continue to target USD1.50 by year end.

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