•  Central Bank meetings take centre stage
  •  Yield differentials come back as major driver of FX
  •  European inflation pressures come back into focus as sovereign debt fears shows signs of easing
  •  Yield differentials support euro and GBP strength vs. the dollar
  •  Yen looks weak

The ECB and the Bank of England meet today. Both Banks are expected to remain on hold, and while the BOE should pass without too much fuss, the markets will be interested in ECB President Trichet's press conference at 1330 GMT.

Obviously the sovereign debt crisis will be a major topic of discussion, but the rise inflationary pressure in the Eurozone may also get a mention. Last week the first reading of consumer inflation for December was released and it rose to 2.2%, above the ECB's target.

A strong German economy is also stoking inflation pressure, wholesale prices rose sharply in December to 9.5% on an annualised basis. Thus, the spectre of inflation has become a very real threat for the Eurozone.

This brings interest rates and bond yield differentials back into focus as a major driver of FX.

German bond yields (the Eurozone benchmark) have picked up, and the market has started to think about the possibility of the ECB raising interest rates later this year, especially if the success of yesterday's Portuguese bond auction is a sign that the sovereign debt crisis has passed its peak.

The negative spread between German 10-year bond yields and US 10-year bond yields has narrowed, which has helped drag EURUSD higher.

EURUSD (yellow line) and German-US yield spread

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The inflation pressures that are helping to lift German yields has also caused the differential between German and UK 10-year bond yields to narrow, which has thwarted EURGBP's decline as you can see in the chart below.

EURGBP (yellow line) and German-UK bond yield spread

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Gilt yields also supporting GBP:

The pound has been very strong recently, and this has matched a widening in the 10-year spread between UK and US 10-year bond yields. But the spread has widened sharply and may be due a break, which may cause a period of consolidation for GBPUSD, as you can see in the chart below.

We believe that in the longer-term the balance of risks point toward more GBP strength. This is due to the differing stance between the Fed and the BOE. The BOE has a sticky inflation problem to deal with, and some large investment houses have pushed forward their expectations for an interest rate hike from the BOE, with some looking for a rate hike in August this year. While the Fed remains committed to a long period of low interest rates, the spread between UK and US yields should continue to widen, which should support a stronger GBPUSD, although we think that the pound may struggle to sustain gains above 1.60.

GBPUSD (yellow line) and UK-US 10-yr bond yield spread.

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Japan:

Interest rates in Japan are expected to remain low for a prolonged period, which should keep a lid on the yen.

Since November, the yield differential between US and Japanese 10-year bonds has moved in support of the USD. Recently the widening in the spread has stopped and we are still in a period of consolidation. We believe that the spread will resume its widening trend and this will put upward pressure on USDJPY going forward.

US-Japan bond yield spread (white line) and USDJPY

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EURJPY and bond yields:

During the second leg of the Eurozone debt crisis in October/ November last year, the German-Japanese bond spread was widening, but EURJPY was falling. However, the relationship between the bond yield differential and the currency pair has come back in line. After widening sharply in recent days, the German-Japanese yield differential has helped propel EURJPY higher.

EURJPY (yellow line) and German-Japanese bond yields

width=630

Best Regards,

Kathleen Brooks| Research Director UK EMEA | FOREX.com
d: +44.(0).20.7398 5024 | f: +44.(0).20.7929.2010 | e: kbrooks@forex.com| w: www.forex.com/uk
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