Interest rates come to the fore

  •  Treasury yields break their long-term range
  •  Political news is bad news for the yen
  •  MPC's growing hawkishness boosts sterling

The market is taking a breather after the Formula 1-style speed of some FX market moves on Friday. The dollar is trading slightly on the back-foot at the start of the European session, and EURUSD is hovering around the 1.3570/80 level. Right now EURUSD is not trending, however above 1.3626 - the top of the Ichimoku cloud chart and a key technical indicator, the euro uptrend is restored.

In the absence of much economic data today the market is likely to concentrate on interest rate differentials after US Treasury yields broke their long-term range on Friday. The market has focused on the surprise shock in the unemployment rate, which declined to 9 per cent in January from 9.4 per cent in December. The US's yield premium is boosting USDJPY, USDCHF and NZDUSD, however, GBPUSD and USDUSD still look fairly strong, so dollar gains are not broad-based across the major currencies.

European equities have had a strong start to the week after the Sentix Investor Confidence survey beat expectations for January. The survey came in at 16.7, up from 10.6 in January, which was a three-year high. Confidence was boosted by prospects of a long-term solution to the sovereign debt crisis being agreed in the coming months along with the continued strong performance of the German and French economies. Sentix now expects the Euro-area economy to expand by 1.5 per cent this year. Interestingly, Europe is picking up while emerging market investor confidence is faltering. The latest Latin American survey was weaker in February, as was a survey for Asia, which includes Japan. This is supportive for the single currency in the medium term.

The pound has had a strong start to the week. The Bank of England announces interest rates on Thursday and the odds are increasing that a rate hike is getting closer. While the market expects rates to remain on hold this month, a small hike as early as May seems more and more likely as worries about high inflation start to dominate discussion on the UK economy. There is a growing perception that if the Bank remains on hold then inflation could become entrenched, which would be considered a policy mistake. The Shadow MPC, a group of economists polled by The Sunday Times on how they would vote on monetary policy, narrowly voted for a hike this month and pressure is growing for the dovish Mervyn King to change his stance. Economic data in the coming days including producer prices this week and consumer prices next week, along with the Inflation Report due on the 16 February are all crucial to the outlook for sterling in the near-term.

After a strong performance in 2010, the yen has come unstuck in recent weeks. Firstly, a sovereign credit rating downgrade hurt sentiment, deteriorating economic data and political issues have all weighed on the yen. On Sunday two candidates backed by Prime Minister Naoto Kan's party failed to win in local elections highlighting the problems facing Japan's PM as he tries to push through a crucial budget and fiscal reforms to try and bring the government's public debt (currently at more than 200 per cent of GDP) under control. Next week will be pivotal for the yen. Fourth quarter GDP is released next Monday and it is expected to show that growth contracted.

In Australia weak retail sales data were brushed off by investors. The Aussie is getting a boost from stronger commodity prices and more hawkish commentary from the Reserve Bank of Australia in recent weeks. On the commodities front, gold is lower, while energy prices continue to rise. The Brent crude contract for March remains above $100 per barrel at the start of this week and rose nearly 4 per cent last week on geopolitical fears emanating from Egypt.

In the absence of much economic data today the markets will concentrate on news coming out of the wires and interest rate differentials. Thus, central bank speakers will be the highlight of the week. On Wednesday the Fed's Bernanke is due to testify at Senate Budget Committee and the ECB's Trichet has two speaking engagements this week along with a raft of other ECB speakers.

Overall, we think the Bank of England will come into focus this week and interest rate expectations in the UK will determine the direction of the pound. Due the opposing inflation and growth concerns, sterling could be in for a volatile time in the coming weeks.

Data Watch:
11.00 GMT (0600 ET) EU German Factory orders last 5.2 M/M 20.6 Y/Y Exp -1.5 M/M 21.3 Y/Y
13.00 GMT (0800 ET) EU Weber speaking on the Euro in Estonia
13.30 GMT (0830 ET) CD Building permits Last -11.2 Exp +2.5
17.15 GMT (1215 ET) EU Mersch speaking
20.00 GMT (1500 ET) US Consumer Credit Last 1.4 Bio Exp 2.5 Bio
23.50 GMT (1850 ET) JP M2/M3 Last 2.3 / 1.8 Y/Y Exp 2.3 / 1.8 Y/Y
23.50 GMT (1850 ET) JP Bank Lending Last -1.9 Exp -1.8
23.50 GMT (1850 ET) JP Current Account Balance Last 962 Bio Yen Exp 1130. Bio Yen
00.01 GMT (1901 ET) UK BRC Retail Sales Monitor
00.01 GMT (1901 ET) UK RICS House Prices Balance Last -39 Exp -38
00.30 GMT (1930 ET) AU NAB Business Conditions Last 6
00.30 GMT (1930 ET) AU NAB Business Confidence Last -3

Best Regards,

Kathleen Brooks| Research Director UK EMEA |
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