Yesterday's better tone has extended into this morning's trading session but there is a clear reluctance to build risk positions. EUR/USD has been struggling beyond the USD1.2150 level, European stocks indices are only modestly higher and gold and yen crosses are broadly consolidating after yesterday's move.

While there has been good economic news this week from countries that include China, Japan, Australia and Italy the market is mindful of last week's disappointing US jobs report and the likelihood that the age of fiscal repair and bank reform will have a dampening impact on economic growth. The comments from ECB President Trichet yesterday that 3mth tenders will be extended through Sept suggest that he is also aware that stresses in the market could continues for some months yet.

Going into the weekend it seems as if the market may be reluctant to hold long risk position.Sterling has been hit particularly hard this morning on the back of poor UK economic data. UK April manufacturing production dropped by -0.4% m/m, compared with a median expectation of +0.4% m/m with reduced production of cars taking its toll.

The data will fuel fears that the economy may fall back into recession once the government starts its massive fiscal tightening program; expected to kick-off after the June 22 budget. Also of concern for UK markets was the publication of the BoE's survey of inflation expectations. The survey predicts that inflation will be 3.3% y/y in a year's time, well above the target of 2.0% y/y.

While UK inflation is presently well above target at 3.7% y/y, the BoE is firmly of the view that excess capacity in the economic will drive the inflation rate lower. However, an increase in inflation expectations risks driving wage deals higher and this will make the BoE uncomfortable.

Next's week UK CPI release is expected to bring a moderation in the headline number back to 3.5% y/y, a strong number here will intensify fears that the BoE may have to bring forward a rate hike. Combined with the scheduled fiscal tightening, this would have very poor implications for growth and potentially for the pound. Cable has retraced half of yesterday's gains pushing down below USD1.4640.

EUR/GBP is creeping back towards 0.8290, though the downtrend on the daily charts remains intact.Comments from new Japanese PM Kan that Japan could face a mess like Greece if it did not urgently deal with its national debt highlight an issue of which the market is well aware. A huge national debt, an ageing demographic and a sharply falling savings ratio suggests that JGB yields will at some point adjust sharply higher.

At present, however, the appetite from domestic investors for the bonds remains sufficient to negate any chance of a near-term crisis.The release this afternoon of US retail sales is set to be the most important set of data of the week. Strong data would help offset the impact of last week's disappointing payrolls numbers and could help the risk trade extend. The market is expecting a moderate rise of +0.2% m/m. Canadian Capacity utilisation data are also due.

Jane Foley

Research Director +44 207 398 5024



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