Sterling slumps on renewed deficit woes.

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Overnight JPY gains stalled in early European hours. Doubts as to whether the US economy will be able to garner enough momentum this year to prompt the Fed to hike rates in Q3, if at all in 2010, yesterday undermined the recent USD’s recovery. This caused the market to question whether the greenback could remain a favoured funding currency going forward and led to corrective pressures on the yen’s five week fall vs the USD. It was the surprising strength of the Nov payrolls data that played a key role in causing the market to re-evaluate its outlook in favour of USD strength last month and Friday’s US Dec payrolls release will be key in resolving some of the concerns regarding the likely strength of the US economy this year. With concerns about the health of Japanese Finance Minister Fujii still unsettled, European investors this morning chose to buy back some dollars via the JPY and vs the EUR this morning, but after an initial push lower in EUR/USD, the gains in the USD lacked momentum.

Sterling suffered heavily this morning vs both the USD and the EUR. The Daily Telegraph ran a story highlighting the budgetary woes of the UK government and emphasising that Pimco’s declaration that it will be a seller of gilts will coincide with the end of the BoE’s QE program and increase the pressure on the UK debt market. EUR/GBP pushed above the 0.9000 level, cable temporarily touched below the GBP 1.6000 mark. With the dire deficit outlook soured further by the fear that May’s election could produce a hung parliament, sterling could remain on the back foot at least through the spring.

In spite of sterling’s fall, there was clear evidence of risk appetite in Asian currencies. The KRW hit a 15 mth high vs the USD as optimism from yesterday’s generally stronger Asian PMI releases encouraging optimism about the Asian economic outlook, though profit taking has followed. In Australia, Nov new home sales rose +0.3% m/m after the previous month’s slump, though AUD/USD remains reluctant to push above 0.9160 while the NZD/USD has not yet convincingly broken the 0.7360 area.

German unemployment data was better than expected at -3K, though this can be linked to statistical changes. Eurozone CPI at +0.9% y/y in Dec was buoyed by energy price rises though with underlying inflation still benign this does not alter the view that ECB inflation will remain unchanged for many months yet.

This afternoon, US factory orders, pending homes sales and vehicle sales are due.

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