Risk correlated trades were broadly higher in the Asia session as risks emerging from EU sovereign credit stories continued to dissipate. CDS prices and yield spreads of peripheral EU members vs. German bonds continued to decline. The firming of confidence enabled the EURUSD to briefly rally above 1.3500 for the first time since mid Nov 2010. Asian regional equity indices were green across the board, including Shanghai which has been under pressure due to the PBoC tightening policy. The rally in risk appetite stems from a combination of growing confidence that the necessary expansion and increased flexibility of EFSF will provide the EU PIIGS with some breathing room, and Trichet's hawkish sounding comments at the last ECB meeting - which has ignited early exit theories.

 

Part of yesterday's EUR rally has been assigned to the jump in German confidence figures. Germany's ZEW sentiment reading illustrated that investors are now increasingly optimistic of the country's economic future, and in addition, respondents believe that the ECB will raise rates by July. As the expectations for interest rate differentials have widened significantly since the EU's recent CPI reading and ECB meeting, the downside risk to the EURUSD looks less convincing. As long as the discussions on the EFSF continue to move in a positive direction, the EUR should be well supported. That said the EU finance ministers left yesterday's Ecofin meeting with no agreement on expansion. Once again there seems to be a major divide between country officials. The Belgian Finance Minister suggested that talks were progressing nicely, but the German Finance Minister Schaeuble seemed to think that any urgency was misguided.

In the UK, Headline CPI for December blew out market expectations, climbing to 3.7% y/y vs. 3.4% prior. The realization to some that BoE rate hike expectations needed to be significantly shifted forward provided the GBP with a lift. Recent comments by MPC members (Posen) seem to suggest that members are still in the mindset that current inflation levels are being driven by short-term, one-off factors. However, in reality these short-term factors have lasted a lot longer and with a greater impact than MPC forecasts had anticipated. At some point, as we have suggested, ad nauseum, the BoE will need to start addressing this lingering problem. And as we have seen with the EUR and ECB, merely the suggestion of an exit strategy will have a profound impact on FX pricing. A stronger sterling is the last thing the UK's fragile growth needs.

Meanwhile, as expected, the BoC kept its target for the overnight rate unchanged at 1.00%. The policy statement reiterated that the recovery in net exports is being held back by a stronger CAD. The BoC's quarterly Monetary Policy Report is due for release later today. The broader markets will be watching for follow through in the equity markets and continued tightening of peripheral yield spreads, the direction of which will define the movement of EUR and risk correlated trades.
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