FOREX ASIA UPDATE - USD

The US dollar strengthened further overnight on a smaller-than-expected trade deficit, and a recovery in investor sentiment.

The dollar was also likely given a boost on stop-loss buying as EURUSD broke down further and traded to a low of 1.2931 from a US session high of 1.2996. Measures of risk aversion eased further overnight, with the Vix index closing at 11.47, and implied currency vols came off further, with EURUSD 3-month implied vols now at 6.25%, the lowest since Nov 21. US equity markets also managed to finish higher despite yesterday's sharp decline in the Nikkei.

We are still cautious however and view yesterday's drop in the Nikkei as suggestive that equity investors are quite amenable to taking profits given the right excuse.

We are not convinced that the global growth outlook is as rosy as policymakers would have us believe and think that investor sentiment could easily take a turn for the worse on any negative economic developments, particularly as trading themes for 2007 have yet to be entrenched.

However, any deterioration in risk aversion at this juncture would likely be quite different from the May/June episode last year, when EM currencies fell sharply, the yen weakened and the US dollar rallied. The May/June episode was triggered by confusion over a hawkish Fed Chairman Bernanke who was keen to emphasise his inflation fighting credentials. That caused US short-term yields to rise sharply and investors took profit on extended positions funded out of the dollar. Also, BoJ tightening expectations were at a peak prior to the episode and were scaled back due to perceptions the BoJ could not hike in the context of a falling Nikkei.

As such, the May/June bout of risk aversion was rather unique in that it triggered strength in the generally risk-averse dollar and weakness in the typically safe-haven yen. This time around, however, risk aversion is likely to be driven by concerns over the global economy and will occur at a time when BoJ tightening expectations are already quite flat.

Also US inflation expectations are quite stable and low relative to May last year and we think the Fed is more likely to swing to rate cutting mode than further tightening.

As such we would expect the US dollar to weaken against the yen and to also lose ground against the euro if investor sentiment were to deteriorate.

In general though high-yielding currencies should suffer the most and we would be cautious on NZDJPY and are currently long AUDNZD in the lead-up to the RBNZ meeting on Jan 25.

Looking ahead and President Bush will speak on his Iraq strategy, however, the details have already been widely flagged in the press so we are not expecting market moving comments. More important for the markets will be the BoE and ECB rate decisions, where we expect ECB President Trichet to adopt a hawkish tone.