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  •  USD rally takes a breather
  •  Rate differentials suggest that EURUSD could be in a range for some time

It's been an important week after the FOMC suggested that the Bank sees the US economy as being on a self-sustaining recovery and US initial jobless claims fell to their lowest level since 2008. This has caused US Treasury yields to surge more than 20 basis points, which has boosted USDJPY to multi-month highs. However, as we end the week the dollar has started to come off and we could be in for a quiet session.

The interesting thing about this shift in Treasury yields is that EURUSD has been remarkably resilient. The Fed's optimism coupled with the improved tone to US economic data is being felt in equity markets across the world, but not in EURUSD, which has moved in a 200-pip range so far this week, hardly the type of move you associate with a serious change in the market's mind-set.

So where does this leave the dollar uptrend? Right now the dollar is definitely gaining strength but it is not broad-based. The main areas where we are seeing the dollar rally is against the other safe havens including the yen and the Swiss franc. The greenback has also made good traction versus the Norwegian Krone; however these moves are mostly on the back of relative differences in monetary policy.

The dollar has benefited from the fact the Fed is unlikely to take more simulative action to boost the economy, while the Swiss, Japanese and Norwegian authorities have all expressed dovish sentiment in the past week. This has been reflected in bond yield differentials. The spread between US and Japanese 10-year yields has risen to its highest level since October and broken out of its multi-month range, as you can see in green line in the chart below. The spread between US 10-year yields and German ones have been widening since the end of November as the ECB has embarked on two rounds of its LTRO liquidity programme (white line on chart). Thus, the gain in US yields could start to slow versus Germany relative to Japan - since that spread has only just started to widen.

US-Japan 10-year yield (green line) and US- German 10-year yield (white line)


Hence you could say that the yield effect has already been felt versus the euro, but is only getting started versus the yen.

But what does this mean for EURUSD going forward? Interestingly we have heard some fairly hawkish talk out of the ECB, which suggests that the Bank is worried about inflation and there won't be any more rate cuts. Likewise, more LTRO auctions are also unlikely after the Bundesbank expressed its concern at the cheap money being offered to banks. This suggests that 1.30 is going to be a tough level to overcome. Although EURUSD is weak within its range, a move back to the January 1.26 lows could take some time as the rate differential suggests euro weakness could slow from here.

Of course deterioration in sovereign concerns could cause the euro to dip another leg lower, but with Italian bond yields continuing to fall - the 10-year yield is currently below 5% - signs of stabilisation in the currency bloc continue to stay alive. But there are elections in France and Greece next month that could disrupt sentiment, but the markets are not focusing on these right now.

We believe that USDJPY will continue to move higher. 84.00 has been a key resistance level; however we believe the pullback today is temporary and a move to 90.00 is possible in the coming months.

GBPUSD was a major mover today; it broke through 1.5700 and got as high as 1.5735; however it then fell back to the figure. Reports suggest the move was caused by some large M&A flow and thus was temporary.

Overall, US inflation data will be key today. I'll be keeping my eye on headline and core annual rates to see whether 10-year Treasury yields can get above the 2.4% high that dates back to October. Oil is fairly stable after yesterday's confusions over the will they won't they release US Strategic Petroleum Reserves (they won't apparently). Interestingly, oil hasn't gone back to its $125 per barrel high and it hasn't followed the trajectory of stocks, thus it may suggest that the market expects the reserves to be released in the near future. This should be on all oil traders' radars right now, although reserve releases tend to have a temporary negative impact on oil prices it could still cause volatility - so be prepared.

Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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