Yield expectations and risk aversion dominated trading in financial markets at the start of the year.

In the US, signs of the subprime and credit problems spreading to the real economy, in the form of softening retail sales and rising unemployment, led to a shift in the Fed's stance. Fed Chairman Ben Bernanke and other officials acknowledged the need to ease monetary policy aggressively, reinforcing expectations that the fed funds target rate will be reduced by at least 50 bp in January. At the same time, President Bush also proposed a USD150 billion fiscal stimulus package to revive growth.

Across the Atlantic, the euro zone economy may not be immune to the US subprime fallout after all. With investor and consumer confidence falling, the euro zone economic outlook has deteriorated. While the ECB has long kept a hawkish stance, with ECB President Trichet stressing the need to keep inflation under control, other members of the policy board may be having a change of mind. Even a hawk like European Central Bank Governing Council Member Yves Mersch appeared to have shifted his tone recently by talking down the growth outlook. If more ECB policy makers share such a view, this would increase the chance of lower euro zone interest rates later this year. Similarly, both the Bank of England and the Bank of Canada are under pressure to cut interest rates to revive growth in the UK and Canadian economies.

While market fully expects lower US interest rates, it has, until recently, not priced in any rate cuts in the euro zone. As such, the apparent shift in ECB's tone could undermine euro sentiment going forward, putting it on the defensive against the US dollar. In contrast, the outlook for the Japanese yen could be brighter, not because Japan's economic outlook is brighter, but mainly as a result of risk aversion.

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