Yen Poised to Extend Overnight Gains on Risk Aversion

January 7, 2013

The Japanese Yen outperformed in overnight trade as Asian stocks declined, driving demand for safety-linked currencies. The MSCI Asia Pacific equity index fell 0.3 percent. The newswires attributed the move to profit-taking after the benchmark regional gauge hit a 17-month high last week.

Broadly speaking, a short lull in headline-driving event risk will give financial markets an opportunity for some reflection in the week ahead.The most significant lingering uncertainty over the coming months remains the outlook for US economic growth and there is much to consider in the aftermath of last week’s volatility

On one hand, risk appetite reacted favorably to a last-minute agreement averting the so-called “fiscal cliff”, but the reaction seemed overdone. While the smaller-scale tax hike baked into the accord is preferable to a far larger and broader increase that would have been triggered without a deal, it is nonetheless a headwind from an economic growth perspective.

Meanwhile, fears of an early end to the Fed’s stimulus efforts after the release of minutes from December’s FOMC sit-down seem likewise overblown. The adoption of the “Evans rule” linking rates to explicit inflation and unemployment targets was already mildly hawkish in that it set a firm exit strategy. However, even if the Fed halts asset purchases by mid-year, it will expand its balance sheet by close to $0.5 trillion.

On balance, the fiscal side of the equation seems to carry a greater degree of near-term uncertainty than the monetary one. That suggests the path of least resistance likely favors risk aversion. Near-term correlation studies suggest such a scenario is likely to prove most damaging for the Australian and Canadian Dollars while producing outsize gains for the Yen.

The economic calendar is relatively quiet in European hours. November’s Eurozone PPI figures are expected to put the year-on-year wholesale inflation rate at 2.4 percent, the lowest in four months. A particularly soft reading may weigh on the Euro ahead of this week’s ECB monetary policy announcement.

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