EUR, JPY flows: EUR gains strongly, JPY still has upside scope

The equity recovery in the US afternoon on Tuesday has reversed some of the risk negative FX moves seen earlier in the day, with the EUR finishing up as the main beneficiary of this week’s action. EUR/USD got a boost from a German plan to reform the debt brake to allow for a EUR 500bn defence fund, and European equities continue to outperform, holding close to the highs. Even so, the EUR may be getting a little ahead of itself. It will take a long time for any impact from a European defence plan to be seen, and for the moment the European data isn’t particularly encouraging. The prospect of tariffs from the US remains, but increasingly isn’t seen as a major concern, with the market now tending to take the view that tariffs will be as damaging or more damaging for the US as the tariff targets. But as long as the European equity market holds steady, the EUR is likely to hold onto gains, benefiting in part from portfolio shifts out of the more expensive US.

EUR/JPY has seen the biggest move overnight, and continues to be sensitive to fluctuations in risk sentiment. The (inverse) relationship between EUR/JPY and US equity risk premia has weakened, but was very strong in recent years and still suggests there is some scope for EUR/JPY gains. But despite risk sentiment softening in recent sessions, it is very noticeable that equity risk premia remain extremely low by historic standards, and are likely to rise further. This could be a sharp move if we see some clearer weakness in the US economy, so this week’s US employment data will be important. Meanwhile USD/JPY continues to look vulnerable due to the big narrowing in yield spreads we have seen, while BoJ governor Ueda continues to talk mildly hawkish. The USD/JPY rally overnight seems unlikely to extend far unless we see a strong recovery in US yields.