International Business Times
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By Kathleen Brooks | March 14, 2011 4:24 PM IST

It's been an extremely choppy start to the morning as the market continues to digest the economic impact caused by the devastating Japanese earthquake and the news that last weekend's EU summit had set in motion plans to increase the size and scope of the EFSF sovereign rescue fund.

The news that the Bank of Japan had provided a record JPY 21 trillion to help the recovery efforts at their meeting earlier today caused a bout of volatility early on. USDJPY had dipped to as low as 80.60 prior to the announcement, but since then has risen to 82.00 as the market priced in the effect of extra stimulus on the yen. The Bank of Japan's emergency operations are designed to ensure there is enough liquidity to 1, ensure that banking institutions are not disrupted by the crisis and have easy access to cash, and 2, to help re-build confidence in risky assets. The extent of the crisis and the continued threat caused by the nuclear damage suggests that the BOJ may provide further stimulus down the line. Indeed, this is what BOJ Governor Shirakawa said earlier today, when he announced that the BOJ would inject as much cash as was needed.

While in the short-term the outlook for the yen is volatile, the medium-term should see it start to weaken. While the BOJ are committed to loosening policy other central banks are moving closer to normalisation, for example the ECB and potentially the BOE. Thus, the interest rate differential should erode support for the yen going forward. However, the prospect of re-patriation of some of Japan's large currency account surplus to help fund the re-build is putting upward pressure on the yen, leaving the currency volatile for now.

Elsewhere, the euro is reacting warmly to news at the weekend that the EU authorities agreed on a "pact" of reforms to the sovereign debt rescue fund and are moving towards closer economic cooperation to try and prevent unsustainable debt burdens in future. The market had low expectations that the leaders' summit at the weekend would come up with anything concrete, yet the announcement that the size of the fund would be extended to its full allotment of EUR440bn, that the EFSF fund would be able to buy bonds of troubled states in the primary debt markets and that the terms of Greece's bailout loans had been softened were enough to spur a mini-rally in the single currency. EURUSD is currently above 1.3900, although it is running into resistance at 1.3950.

Although nothing has been set in stone, the announcement of these reforms is earlier than expected; the next summit is 24/25 March where the details of these changes will be hammered out. It is encouraging that Germany has thrown its weight behind 1, extending its guarantee to the bailout fund, and 2, allowing the fund to purchase bonds directly in the market. Without the support of Europe's largest economy, plans to shore up the fund would have undoubtedly failed.

There is some criticism of the plans this morning mostly centring on the fact that any changes to the EFSF's form and structure still have to be agreed at the national level. Also, the bond purchase scheme only covers countries that have already defaulted - Greece and Ireland - and the plan essentially does nothing to alleviate the debt levels of the troubled economies. Added to this, until Ireland agrees to increase its low corporate tax rate there will be no softening of the terms of the Irish bailout loan. Both sides are playing hardball about this, however Ireland's hand remains weak at this stage and we think it will eventually bow to German and French demands in return for less onerous terms of its loan.

The euro has been the chief beneficiary of this development; however bond yields in the troubled peripheral states remain fairly flat at the start of the European session. The credit market is trying to digest exactly what this means for the periphery before it will jump into buying up bonds of Europe's weaker states.

Stocks markets have opened slightly higher, picking up from where they left off on Friday. For now stocks have shirked a move lower after dipping below some key technical levels last week. The market is in pause-mode right now, and sentiment over the next few days will be crucial to whether the markets continue their uptrend or we get a deeper correction that signals the start of a downtrend. Oil and gold remain fairly flat. Energy markets should remain volatile as more and more countries speak out against nuclear power in the wake of the Japanese earthquake. Germany and Australian authorities have done so already today and more may follow. This makes other forms of energy more attractive. Already we have seen the price of Nat gas move higher as Japan looks to import other types of energy while its nuclear reactors are still down. Eventually this could put upward pressure on the oil price.

Elsewhere, it's fairly data-lite with a few ECB speakers the main highlight. Obviously news flow from Japan has the potential to dent sentiment along with any further news from the Middle East.

Data Watch:
Euro Area 12:00GMT (0800 ET) ECB's Weber Speaks
Euro Area 18:30GMT (1430 ET) ECB's Bini Smaghi Speaks
18.00GMT (1400 ET) World banks Zoellick and WTO's Lamy Speaking
Australia 22:00GMT (1800 ET) RBA's Debelle Speaks
China 0200 GMT (2200ET) Actual FDI (Feb) y-o-y n/a 23.40% last

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Kathleen Brooks| Research Director UK EMEA |

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