The US dollar fell overnight despite stronger than expected non-manufacturing ISM. EURUSD rose to a high of 1.5520 in the US session from a low of 1.5426, as oil rose US$4/bbl to just over US$120/bbl. However, risk appetite was stable with the S&P500 down slightly, while the Vix index held above 18. Data released overnight was consistent with a mild but potentially drawn out slump in the US. Non-manufacturing ISM in April actually rose above 50 to 52.0 up from 49.6 in March and against market expectations of a further decline. A breakdown showed a decline in business activity, but an improvement in employment as well as higher price paid. The other development was the Fed Senior Loan Officer Opinion Survey (SLOOS) showed a further tightening in lending standards in April, particularly for non-mortgage loans such as business and other consumer loans. Our economists believe that this information would have been available to the FOMC last week, so it is unlikely to change Fed thinking. Fed Chairman Bernanke was on the wires this morning, but did not comment directly on monetary policy. He did say that house price declines could further damage the real economy. EURUSD has already moved quite sharply over the past two weeks, so given a pause in market moving data, it is not such a surprise to see the pair consolidate. In our marketing trips in Japan and Australia over the past two weeks, we found some large asset managers were still negative on the US dollar. That suggests that real money flows could support a stronger US dollar, if the right set of conditions push EURUSD below pain thresholds for long EURUSD positions. However, data this week is relatively light, with pending home sales due tomorrow of the only real interest. In the Eurozone focus is of course on the ECB on Thursday, and potentially Trichet could tone down his hawkish stance a little, but that might be difficult in lieu of oil at near US$120/bbl again. We continue to target EURUSD at 1.55 over 1 month and 1.47 over 3 months.

Eurozone inflation prints last week finally showed some easing in price pressures, but the hawkish ECB were quick to remind markets the central bank's base case has not changed. While the Governing Council is likely waiting for downside trends in prices to develop-barely two weeks ago further hikes were being openly contemplated-the speed of deterioration in data was perhaps unexpected and we expect Trichet to voice greater concern about growth at this week's meeting. Zone-wide retail sales numbers and German industrial production data is due later this week and further downside may see industry become more vocal about the need for rate cuts. Our short-term tactical strategists have entered a short EURGBP trade overnight, figuring that the odds are more likely that the ECB will be slightly less hawkish in light of the soft German Ifo, while we are expecting no fresh developments out of the BoE on Thursday.

Risk appetite has improved sharply in recent weeks and this has been the primary reason for USDJPY shifting higher. The Vix index has fallen from around 22.5 to just under 19 currently, while US bank 5-year CDS spreads have fallen by 70bp to just under 100bp since mid-April. On the Japanese side, Japanese margin traders have tentatively re-established short yen positions. The net short yen exposure at the Tokyo Financial Exchange stood at Y239 bn as of Thursday, up from Y208 bn a week prior, with EURJPY attracting most of the interest. While risk appetite has been improving, Japan's economic situation has been deteriorating in response to softer global economic conditions. First it was Japan's trade balance for March revealing a sharp contraction in exports to the US, and a sharp slowdown in exports to Europe and Asia. Last week, industrial production for March fell sharply, lead by less production in export-orientated sectors. While we don't trust the latest improvement in risk appetite, we do recognise that it has some persistence to it in the near term. However, we maintain our outlook for a generally firm yen, and target USDJPY at 100 over 3 months in the context of US dollar strength. Japan is on holiday again today.

The unexpected rise in retail sales in March has alleviated some immediate risks in the near-term. We know that domestic demand is moderating but it seems that the pace of the slowdown is not enough to drive immediate weakness in AUD. We spent the week marketing in Australia and New Zealand last week, and clients were mixed on the AUD, although we suspect that foreign asset managers are long the currency. Clients were uniformly negative on the NZD however. The RBA announce rates today, and we expect them to keep rates on hold, but maintain a slight hawkish tone to an otherwise neutral stance. Both Australia and New Zealand get labour market updates on Thursday, with New Zealand employment for Q1 due, and Australian employment for April due. In both countries, we are hearing reports of labour hoarding, meaning that firms are reluctant to cut jobs despite slowing demand, for fear of not being able to re-hire at a later date. This implies that employment will be a lagging indicator, more so than is typically the case. Please see Strategy Comment "Clients Down on NZD" on FXWeb for further details of our marketing trip to Australia and New Zealand last week.