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There are two main forces shaping exchange rates. The first is the continued depreciation of the Japanese yen and the second is the appreciation of the euro.

The newly elected government in Japan is pursuing an aggressive stimulative policy to strengthen the economy and finally arrest deflation. Many, however, doubt that the combination of new government spending and measures by the BOJ are sufficient in themselves to push inflation to even 1% this year. Neither the BOJ nor the Abe government itself believes it, as reflected in their forecasts.

Japanese officials are encouraging the market to weaken the yen. Yet previously Japanese officials have tried talking the yen down, but with little results. What makes this time different? Although the push back against Japanese official rhetoric appears to be widening, there is more to the yen's weakness than official desires.

There are several other considerations. Japan's once-heralded trade surplus has swung into deficit. Its exports are weak. Part of the weakness of Japan's exports to China may be a reflection of the territorial dispute, but also Japan's reliance on energy imports has intensified after the nuclear accident. In addition, the recent CPI data indicates that the deflationary forces have hardly moderated.

Moreover, the same consideration that has pushed the Swiss franc to a year and a half low against the euro, has also weighed on the yen. There has been a collective sigh of relief, as it were; the need for safe havens has diminished. The yen and Swiss franc benefited from the disruption of the global economy and the finance sector in particular. European officials have successfully maneuvered the EMU project away from the edge of the abyss. The worst of the US fiscal cliff appears to have been avoided. The Chinese economy, which has slowed for the better part of two years, appears to have stabilized.

It is not just that the yen (and Swiss franc) are weak, but the euro has been appreciating. Reports suggest real money and official interest, especially out of the Middle East, have joined speculative forces (gross long euro future contracts in non-commercial hands was at its highest level even before the euro finally succeeded in breaching the $1.34 cap).

The greater than expected repayment of LTRO funds has served to accelerate forces already at work essentially tightening monetary conditions. Bank borrowing at the normal repo operations has fallen off and now they repay 137 bln euros. If the second LTRO is paid down in a similar proportion, another 148 bln euros will be removed.

The ECB is passively accepting the tightening of monetary conditions that has resulted in a nearly 25 bp backing up of Euribor rates. As the ECB meeting on Feb 7 approaches, this will likely become an increasingly key point. Broadly consistent with this is the news reported today that money supply (M3) growth slowed to a 3.3% year-over-year pace from 3.9% in December. with private sector loans shrinking 0.7%.

The euro zone economy may still be contracting here in Q1, and especially so, if one excludes the German locomotive. Later this week, a new record high in unemployment (Dec. estimate 11.9%) for the region is likely to be reported. Inflation, and especially excluding administrative prices, is low. Europe can ill-afford a tightening of monetary conditions.

Meanwhile, the Federal Reserve's balance sheet continues to expand, a new record of $3 trillion was recently set. If an FOMC meeting can be a non-event, this week's meeting is. It was just at the last meeting that the decision was made to expand QE3+ by $45 bln of Treasuries a month. It is far too soon to expect a serious review.

The FOMC is unlikely to alter its economic assessment very much, though some recognition of the improvement in global conditions may be warranted. Although the FOMC is not going to take new action, it would not be very surprising is one of the new Fed President voters rotating on, dissent to make point, though with little impact.

Progress toward the 6.5% unemployment or 2.5% inflation is little changed. At midweek the US will report the first estimate of Q4 GDP. This preliminary report is subject to great revisions. The consensus is for 1.25-1.50% annualized GDP. First quarter growth is expected to be around the same rate.

The Dec jobs report, at the end of the week, is likely to come in line with the recent averages. Through December, the 3-month average net job growth was 151k and the 6 month average was 160k. Over the past 2-years the US economy has created an average monthly net 153k jobs. Comments from Fed officials suggest a desire to see closer to 200k a month for several months.

It is a relatively light data week for Europe. The main highlight in Europe will be the PMI readings at the end of the week. German employment data the day before may get an extra look for confirmation that softness in Q4 ended. However, the unemployment queues likely grew as they have in every month since last April.

Japan will share several data points, including retail sales, employment, industrial production and the PMI. However, given the more aggressive policy by the Abe government, the economic data is too backward looking. In some ways, as we have seen with trade and inflation reports, the worse the data, the more necessary Abe's stimulus may appear, and weigh on the yen.

Lastly, we note that there are five emerging market central banks that meet this week. We expect 25 bp rate cuts to be delivered by Hungary, India and Colombia. Note that Colombia is also expected to extend and possibly expand its $20 mln a day purchases. We expected Israel and Malaysia to keep rates steady. If there is a surprise, we think it most likely to come from Malaysia, where inflation is low and the economy weak.

Source: Contours Of The FX Market In The Week Ahead