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This week has seen a couple of unusual developments that are worth pointing out.

1, USDJPY has diverged from 10-year Treasury yields. Treasury yields are falling as they attract safe haven flows caused by the Greek debt crisis, while USDJPY has broken higher. The question now is how long can this last? The reason for the USDJPY breakout above the key 78.10 200-day sma resistance level was Tuesday's action by the Bank of Japan. It expanded its stimulus package to boost economic growth and also employed an explicit inflation target of 1% in the near term and 2% in the medium term. Since CPI is currently in deflationary territory at -0.2%, the Bank may need plenty more stimulus for it to reach its first target rate let alone its second. Thus, the BOJ's main focus has to be targeting inflation going forward. In contrast, the Fed is targeting inflation at 2% in the medium-term. However, its dual mandate - to provide stable inflation and full employment - means that it can be slightly more flexible than the BOJ now that the unemployment rate is falling. Hence, central bank policy action is one of the reasons for the divergence in USDJPY/ US Treasury yields.

But where is this pair going to go from here? We are a bit wary of the dollar, the Fed has pledged to keep rates low until 2014 so that could limit greenback upside. However, in the near to medium term there is the capacity for the yen to weaken further. Above 78.50 opens the way to 79.55- the October intervention highs - and then to 80.00 - a key barrier level - and 80.25 - the August intervention highs. If you are looking for a stop-loss level then I would recommend a trailing stop loss starting at 78.10 - the 200-day sma - and now a key support level.

USDJPY (white line) and US 10-year Treasury yields (orange line)


2, Peripheral European debt is moving in the same direction as safe havens... The continued threat of default in Greece has only had a minimal impact on Italian, Spanish and Portuguese bond yields and Italy had a very successful bond auction yesterday. Bond yields have moved slightly higher today, but it doesn't detract from the overall direction lower for peripheral European yields.

We believe the resilience is due to a couple of things: 1, Everyone believes the Greek bailout negotiations will go down to the wire but that a deal will be reached and default on March 20th will be avoided. 2, The prospect of Greece leaving the Eurozone is no longer such a taboo subject and the Eurozone could survive without Greece in it.

However, the biggest impact on peripheral yields is ECB LTRO liquidity, the next auction is due on 29th February. Markets adore liquidity and central banks are providing it by the cart load right now. For the ECB, LTRO money is not only propping up the currency bloc's banks but it is also seeping into sovereign markets so is thus working as an effective way to bring down credit risk in the weakest economies.

Thus, although issues in Greece are fuelling demand for German bunds and US Treasuries (purple and white lines on the chart below), ECB action has caused a breakdown in the inverse relationship between safe haven yields and European peripheral yields, with them both falling together, as the ECB reduces credit risk for Europe's periphery. (Italian, Spanish and Portuguese yields are green, orange and yellow respectively on the chart below).

This suggests that even if the ECB is expanding its balance sheet, which is now bigger than the Fed's, it may not weigh on the euro. Typically when a central bank's balance sheet expands it means a weaker currency, but the ECB is not a typical central bank and when its actions reduce credit risk it can help to prop up a currency, which is why we have seen EURUSD find good support at 1.3080 this week even though Greek tensions have notched up a gear.

Converging yields: the safe haven and Europe's peripheral bond markets are moving in the same direction. This chart has been normalised to show how the yields move together.


Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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