This morning's downgrade of Japan's sovereign credit rating by one notch to AA- with a stable outlook took the market by surprise and weighed on the yen in the immediate aftermath. However, credit rating agency S&P had been reviewing Japan's sovereign rating for the past year, so it is not surprising that they took action. The agency cited demographic pressures, weak growth and deflation as the reason for the downgrade and also said that it didn't believe the ruling DPJ party had a credible fiscal strategy. This makes the coming few months pivotal for the government. It presents its fiscal plan this summer, and it is increasingly likely that it will include the controversial consumption tax, that is now considered one of the only ways to reduce the nation's fiscal burden.

While the yen spiked lower immediately after the news, a rival rating agency announced that it had no plans to change Japan's rating, which coincided with USDJPY falling back below 83.00. Although the spotlight is now shining on Japan's debt issues, its situation is different to that of peripheral Europe. Only 10 per cent of its debt is held by foreign investors, which shields it from a sell-off, thus limiting the chances of a bond-buyers strike, a la Greece and Ireland. Interestingly, 10-year Japanese government bond yields are actually lower now than the most recent peak reached in mid-January.

The downgrade caused a flight to the dollar, which weighed on risky assets. EURUSD is hovering around 1.3700 and GBPUSD is close to 1.5900. It could be a jittery day for the markets, although stocks are slightly higher since the European open and US futures are also pointing to a higher open. Risky assets were given a boost by the Federal Reserve, who reinforced its commitment to quantitative easing until at least the end of the second quarter this year. There were also no dissenters since Hoenig left the Federal Reserve at the end of last year. Thus, the FOMC is singing from the same hymn sheet and the song is more support and low rates until unemployment improves.

The contrast between the Fed and the ECB was brought into clear focus today when ECB President Trichet said that the Bank will do its utmost to protect price stability in the region. While the Fed tethers monetary policy to unemployment, the ECB is tethering it to inflation. The rise in inflation to 2.2 per cent last month and signs that cost pressures are building in Germany are obviously affecting the Bank. While the ECB seems closer to raising rates than the Fed (which is not the same as the ECB actually raising rates in the near-term) then the euro should benefit.

It is as if the GDP print didn't happen in the UK, as the GBPUSD rate is back to levels reached earlier this week. The markets are also expecting interest rate increases by August, and until the focus shifts back to the deteriorating growth outlook in the UK, then the pound should remain supported.

Eurozone confidence data was slightly mixed. Economic confidence remains at a 3-year high, while industrial confidence was higher with service sector confidence lower. Ahead today, US durable goods orders, Chicago Fed national activity index and jobless claims data will be digested by the market. The market will be looking to see an improvement in the jobless claims data. The 4-week moving average started to rise again last week to 416.5k up from 411k the week before, later today we could get a better idea if this was a blip or a deterioration in the trend.

Elsewhere, gold remains fairly static post the FOMC meeting. As the global economic outlook improves and further QE by the Fed post June 2011 seems unlikely, the attractiveness of the yellow metal is eroded. The Aussie dollar is also under pressure today after Prime Minister Gillard announced a flood tax to help with the re-build effort after the devastating floods.

Data watch:


13.00 GMT (0830 ET) EU Gonzalez Paramo Speaking

13.30 GMT (0830 ET) US Durable Goods Dec Last -0.3 Exp 1.5

13.30 GMT (0830 ET) US Core Capital goods Last 2.6 Exp 3.0

13.30 GMT (0830 ET) US Initial Claims Last 404K Exp 405K

15.00 GMT (1000 ET)US Pending Home sales Last 3.5 Exp 1 MoM

18.00 GMT (1300 ET) EU Tumpel Gugerell Speaking

Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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