Conditions for US dollar strength improved overnight with Eurogroup's Juncker and ECB's Weber essentially warning against further EUR strength by emphasising excessive volatility. US 2-year Treasury yields jumped by 13bp, partly in response to Fed officials sounding the alarm on inflation, but also due to positioning and a sharp rise in UK short-end yields. In this context EURUSD has traded from a high of 1.5985 down to a low of 1.5846, while USDJPY has traded up to a high of 102.72 from a low of 101.70. Economic data released overnight was mildly disappointing with the Philadelphia Fed manufacturing current activity index falling -24.1 in April, from -17.6 in March, while initial jobless claims rose to 372k in the week of April 12 from 355k the week prior. Fed Vice Chairman Kohn focused on risk management and financial stability and did not directly address the monetary policy outlook. However, both Lacker and Fisher sounded the warning on inflation, with Lacker arguing that inflation is a 'problem' and that he uncomfortable with simply waiting for economic slack to bring it down. Fisher, who dissented at the last FOMC meeting, said that he "maintained a strong reluctance to further general monetary accommodation&.There are ways to stabilise the economy beyond opening the monetary policy spigot'. However, our economists do note that Fisher was a little more optimistic in his description of recent actual inflation data. As we have been arguing, the outlook for the US dollar in part rests on the Fed becoming more concerned about the inflationary consequence of its aggressive rate cut actions to date. The other leg to a dollar rebound is for the ECB to adopt a more neutral bias, although with strong inflation data in the Eurozone that may not be forthcoming in the near-term. Still we think upside to EURUSD at these levels is limited, and our bias is for US dollar strength, targeting EURUSD at 1.55 and 1.47 over 1 and 3 months respectively.

Comments by European officials provided grounds for the markets to be more cautious in pushing EURUSD much higher. Eurogroup chief Jean Claude Juncker said financial markets had failed to understand the message of the G7 statement. Separately, Bundesbank Chief Axel Weber said that the "G7 statement speaks for itself". However, with Eurozone inflation data coming in strong earlier in the week, the likelihood of the ECB changing it's hawkish rhetoric just yet is limited. As such, the threat of intervention is still relatively remote.

BoJ Governor Shirakawa has spoken this morning at a branch managers' meeting and noted that the economy is slowing due to high oil prices. The BoJ will also release its branch manager's report, and the market is expecting further downgrades for various regions. Industrial production for February was revised yesterday, and showed output was up 1.6% m/m, versus the prior estimate of 0.9% m/m. The data is operating off a new base, and METI forecasts suggest that IP should hold relatively firm over the next few months. Otherwise data is following a deteriorating trend in Japan - the Reuters monthly Tankan (not to be confused with the BoJ Tankan), was released yesterday and showed manufacturing sentiment at its lowest since July 2003. With domestic developments not evolving rapidly enough to drive the currency, we expect the yen to trade as a function of global risk appetite. As such we continue to target USDJPY at 100 over 3 months.

Australian merchandise imports for March were released yesterday, and rose by 2.3% m/m, after easing 0.2% m/m in February and gaining 6.2% m/m in January. Australian terms of trade for Q1 are due today and are likely to show a 3% q/q gain for export prices and a 0.5% q/q gain for import prices. The terms of trade are likely to improve further in Q2, as new contract prices for iron ore and coal take effect from April onwards. The terms of trade however are a double edge sword. While, it's true that gains in commodity prices have boosted the value of the AUD, we also believe that the gains in many commodity prices have been highly speculative in nature, and are at risk of correcting lower as the US dollar stabilises and rallies again. We continue to target AUDUSD at 0.9100 over 1 and 3 months.

Sterling rallied following comments from European officials and news discussing a possible BoE mortgage plan, which helped UK short-end yields to shift higher. After intense lobbying by the banking industry, the bank is supposed to draw up a plan that is intended to make it easier for mortgage lenders to raise money. The industry, Bank of England and the Treasury have spent weeks hammering out the details and are close to reaching an agreement. An announcement is not expected before next week, however. We expect the next rate cut in June, supporting our view for cable to retreat further. In other news, the Telegraph reported that a Chinese Sovereign Wealth fund has built up a 1% stake in a major UK oil producer. We have recently expressed concern that the BoE's troubling tolerance for sterling weakness may result in a sharp reduction in official buying of GBP by reserve managers. There are upside risks to GBP as UK assets may be looking attractive at current levels and offer opportunities for countries seeking sustained diversification in the face of dollar weakness.