London Session: Japan news trumps the UK sovereign downgrade

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It's a potentially explosive start to the week, driven by three important events. The first is the Italian election results due later today (see below for more details), the second was the UK credit rating downgrade on Friday and the third is the expected appointment of a new governor of the Bank of Japan.

GBP gets a pounding

Looking at the UK downgrade first, the market impact has been fairly muted so far. Gilt yields actually fell at the open this morning. A downgrade had been expected by the market and was pretty much priced in: 10-year gilt yields have been trending higher since the end of August as the safe-haven trade started to get unwound , and are close to their highest level since April last year. However, 10-year yields are still extremely low compared to past history, at below 2.2%. We tend to think that he downgrade supports further QE from the BOE to support the UK's growth recovery, which could keep a lid on yields in the near term. Here are our main thoughts on the downgrade:

•  They support more QE which is positive for the Gilt market and negative for sterling. GBPUSD may fall below 1.50 in the coming days. It found support at 1.5080 this morning, which could be a temporary bottom. The prospect of more QE could see us get back to 1.47 in the medium-term.
•  While the downgrade is not a major market-moving event in itself, it is another reason to sell the pound.
•  The focus will now shift to the Budget on 20^th March. If we don't get a growth plan from the government then we could see further selling pressure on the pound.
•  The biggest risk from this downgrade in our view is a political crisis. The Chancellor is looking extremely weak, and it is likely to put immense pressure on the coalition as the Prime Minister tries to balance the pro-growth forces with the pro austerity forces within his government in the coming months.

BOJ governor steals the spotlight from GBP

There was some expectation that the UK could come under significant selling pressure at the start of the week, but actually that did not come to pass as the sharp decline in the yen has been the focus of the G10 FX market so far today. The decline was triggered by speculation on the next BOJ governor. A source said that the government's choice for Governor is the current President of the Asian Development Bank Haruhiko Kuroda. A formal announcement is expected in the middle of this week. Kuroda has overtaken the more moderate Muto as the leading candidate. Kuroda is an academic who has in the past advocated using unorthodox monetary easing measures, thus, if he is appointed governor later this week then Japan could be entering an era of uber-easing in an attempt to reach the 2% inflation target. This had a big impact on the yen, with USDJPY moving to its highest level for nearly three years. The decline in the yen has been broad-based as the market digests a more dovish complexion at the BOJ. However, the yen bears need to watch out. The appointment of the new governor comes hot on the heels of the G20 and talk of currency wars. While there was no public pressure on Japan at last week's G20, we believe there would have been private pressure on the Japanese not to manipulate the yen lower. Thus the potential appointment of Kuroda could also herald the next round of currency wars.

In terms of how to play this, the next couple of days could see the yen being sold on any strength. USDJPY has dipped back below 94.00 this morning after the rush to sell the yen caused it to become seriously oversold in the short term. We believe USDJPY could find some buying pressure ahead of 93.50, and a move above 95.00 is possible in the coming days. It is also worth remembering that USDJPY could also face volatility on the back of the sequester in the US, which is due to come into force on Friday. The market hasn't really focused on the prospect of austerity in the US, and if this heralds the start of public sector spending cuts then we could see some risk aversion in the coming weeks, which could drive flows into the dollar.

Italian elections - why so calm?

The markets seem to be expecting a very benign outcome from the Italian elections, although European political analysts have been calling the outcome the most uncertain for decades. The trouble is that there is a polling blackout in the week leading up to the election, which adds to the uncertainty. Some newspaper reports this morning suggest that Berlusconi's centre right party gained traction over the last week, so too has the Five Star Movement, which is calling for a referendum on euro membership. This election is considered a vote on fiscal austerity and toeing the Germanic - European line. Whatever the outcome, Italy's relationship with Europe may get pricklier.

Even a win for the most market-friendly coalition of the centre left party led by Bersani and former PM Mario Monti is unlikely to be free from calamity. Bersani's coalition includes the extreme left and it could be hard for them to agree to common ground along with Monti - the pro austerity/ pro reform candidate. The fact that Italian bond yields remain sub 4.5% is astounding to me. A win for Bersani and co. could ignite the ire of the public as they start to realise that "temporary" tax rises are actually here to stay. Added to that, the weak coalition government of Mario Prodi collapsed in 2008 after he could not win enough votes to pass a bill for voting reform, which allowed Berlusconi to take power. Thus, even if Berlusconi does not win an outright majority today, he is likely to be waiting in the wings to swoop on any weakness in the next government.

Bond yields could move higher in the coming months, which support a weaker euro. EURUSD is testing a key support level at 1.3215 - the top of the daily Ichimoku cloud. If we get below here it is the end of the technical uptrend, which supports a steeper decline back to 1.30 in the coming weeks. Thus, as the results of the election come out after 1400 GMT we expect volatility in the euro crosses. A daily close below the top of the daily cloud is a bearish development for this cross.

We don't think this weekend's election of the pro-austerity candidate in the Cyprus elections will have any impact on the markets in the long-term. The news may have helped the euro find its felt after falling as low as 1.3180 earlier, as it makes the passage of a German parliamentary vote on a Cypriot bailout package more likely next month.

One to watch: EURUSD

Best Regards,

Kathleen Brooks| Research Director UK EMEA | FOREX.com

d: +44.(0).20.7429.7924 | f: +44.(0).20.7929.2010 | M: +44 (0) 7919.411.957 | e: kbrooks@forex.com| w: www.forex.com/uk

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