Euro Resilience Noteworthy, UK Trade Improvement, Japan Update

Peripheral European bonds are under pressure and the euro slipped through yesterday's lows against the dollar, but we continue to suspect the price action is largely technical in nature. The dollar's downside stalled encouraging momentum traders to square up positions. The underlying signal is still one euro resilience as it appears the interest rate story continues to trump the debt crisis story.

The euro managed to record only a marginal new low, it was recorded in early European activity and stayed there only briefly. The weakness was not confirmed by sterling, which held above yesterday's lows. Divergences on the short-term momentum indicators suggest the euro is likely to recover in North America today. Top end of the immediate range is seen around $1.3930 and a break of could be the first signal of another run above $1.40. On the other other hand, a break of $1.3850 would likely force another round of position squaring.

The flare up of the European debt crisis had previously weighed on the euro. The main channel, we argued, was through the safe haven flows into Germany which lowered interest rates. However, the ECB's hawkishness is winning out as the German 2-year yield remains 20 bp above there it was last Wednesday before Trichet signaled a rate hike. Despite the peripheral pressures, the 2-year German yield is off less than 3 bp this week and the differential with the US is at 103 bp which is within a few basis points of the multi-year high reached just before last weekend.

Sterling is trading on a somewhat firmer note as the BOE's two-day monetary policy committee begins its two-day meeting. Few if any expect a rate hike quite yet, but the risk may be more substantial than is generally appreciated. With inflation running persistently above target and the economy expanding after the Q4 contraction, the market anticipates a hike in Q2. While the ECB and Federal Reserve have taken measures to become more transparent (isn't the use of the phrase "strong vigilance" a pre-commitment, which Trichet says the ECB never does?), the Bank of England has relished in surprising the market.

The past weakness of sterling on a trade-weighed basis was one of the factors that may have helped lift UK inflation, but that weakness has not been sufficient to reduce the UK trade deficit. Today's trade figures offer much needed relief. The total trade deficit fell to GBP2.95 bln from a revised GBP5.47 bln in December (was GBP4.83 bln) and significantly better than expected (~GBP4.0 bln). The Jan shortfall was the smallest since Feb 10. The breakdown showed exports rose 1.3% while imports fell 1.3%.

Japan's January machinery orders rose 4.2% more than twice the consensus. The data lends credence to the BOJ and government view that the economy is recovering after contracting in Q4. The magnitude of the contraction may be revised tomorrow to 1.2% annualized from the initial estimate of -1.1%. However, the focus in Japan is currently on fiscal policy, politics and foreign affairs. S&P indicated earlier today that it was not convinced that the current political environment will permit needed fiscal and structural reforms that are needed to stabilize the high and rising public debt.

While Prime Minister Kan named a new foreign minister today, China and Russia seem to continue to probe and push Japan. Russia has reportedly put a military installation on one of the disputed islands, while China is reportedly drilling oil in disputed waters. It has taken the dollar the first three days of the week to recover from last Friday's slide against the yen. The high that day was just above JPY83.00. Look for this area to hold and the greenback to ease back to JPY82.40-60.