It's been a quiet session as the markets lead up to ECB meeting. Major markets are stuck in ranges and stocks are lower. This has allowed the markets to focus on news events. Firstly, the tittle tattle between currency bloc members about whether the euro is overvalued or undervalued has heightened event risk for the single currency as we lead up to the ECB meeting tomorrow. The news that Berlusconi is rapidly catching up with the leading centre-left party as we approach the Italian elections in a few weeks has focused minds on Italy's precarious financial position. Added to this, more UK banks have been embroiled in the Libor-rigging scandal and majority state-owned RBS was fined GBP390 million for manipulation in yen and Swiss franc Libor rates.
Financial stocks are getting hit hard in Europe today on both fronts - regulatory pressure and also political risk. Spanish and Italian 10-year bond yields have risen and this has weighed on EURUSD and also EURJPY, which both have a high correlation to sovereign risk in the currency bloc. EURUSD fell below 1.3500 earlier, however 1.3470 held as support reinforcing this level as a short term low. After breaking above the key 127.10 short term resistance level during the Asian session, EURJPY has fallen sharply. 125.80 should act as support ahead of the ECB.
The yen has been volatile today - the Asia session reacted to news that the current BOJ governor would be leaving his post early, which will allow the government to install a dovish governor as his replacement. Shirakawa was due to leave in a April, and the market has been priced for a dovish BOJ governor for a while, so the market changed course fairly quickly in the European session, with the yen easily clawing back some recent losses.
No French-German cordiale entente
Angela Merkel has taken an opposing stance on the value of the euro compared with her French counterpart Francois Hollande. Her spokesman said earlier that the euro appreciation is a sign of greater confidence in the region and a stronger euro is "not a bad thing". This compares with Hollande, who yesterday questioned why the euro is a free floating currency, and suggested governments'', and not just the ECB, should have control over FX policy. The Franco-German relationship of yore is no more. Hollande may have been feeling brave after his foreign policy triumph in Mali, but today he has been cut down to size by Berlin.
ECB reticence could boost euro
While the prospect of an actual currency war, complete with capital controls and protectionist measures still remains quite small in our view, there has been an uptick in rhetoric especially in the developed world. We doubt the ECB will actually join the debate, and we imagine Draghi tomorrow will avoid the question with his usual flare. If he does do this then we may see the euro rally, particularly against the USD and the JPY. Two resistance levels of note in both crosses include 1.38 and 128.50. However, that may be the last hurrah for the euro in the medium-term as Italian elections risks (namely the re-election of a certain Silvio) start to mount.
Elsewhere, economic data has been fairly thin on the ground today. Mortgage applications were stronger in the US for last week, and factory orders in Germany popped higher as expected in December; however the recovery remains a fragile one. Tomorrow is a much more action-packed day starting with BOE Governor-elect Mark Carney's testimony to Parliament at 0945 GMT then the ECB press conference at 1330GMT/ 0830 ET. Don't forget initial jobless claims form the US too.
One to Watch: EURJPY
This cross is extremely sensitive to changes in the spread between German and Spanish/ Italian 10-year bond yields. If this continues to widen, then EURJPY may come under pressure. If the ECB meeting does lead to some upward pressure on the euro, we may see sellers start to come in around the 128.50 mark. Support lies at 126.60 then at 124.50 in the short term.
Chart 1: EURJPY daily chart
Kathleen Brooks| Research Director UK EMEA | FOREX.com
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