The US dollar strengthened modestly in the North American session, helped in part by firmer than expected retail sales. However, equity markets still fell, with the S&P500 down 0.3%, while Treasury yields rose modestly, with the 2 and 10-years up by 1 and 4bp respectively. Retail sales for March rose by 0.2% m/m, following the -0.4% m/m decline in February and above consensus for a flat result. In yesterday's edition we wrote that early morning US dollar rally was overdone in response to developments at the G7, and indeed EURUSD has retraced some of its losses. Any sustained improvement in the US dollar is likely to require tangible reasons for the ECB to adopt a neutral bias, which in turn would require confidence on their part that inflation expectations are anchored. It would also require commodity prices to weaken, which in the absence of a position unwind, will need some more evidence that the global economy is slowing. Finally, it would require that Fed officials signal more concern about the inflationary impact of their sharp rate cuts to date. Overall the data in the US has been consistent with a mild recession, as indicated by not only last night's retail sales, but also in the shallow declines in the ISMs as well as relatively contained job losses in comparison to past recessions. The key driver of exchange rate trends at present is the variable lags at which the global credit shock impacts on the various economies. Following the US, the UK more immediately experienced weakness in its housing data, but we should also keep in mind that PMIs in the Eurozone are also deteriorating, particularly in Spain and Italy. Meanwhile, in Australia this week we have seen a sharp deterioration in housing approvals data. Investors need to be aware that during the recessions of the early 1980s, early 1990s and early 2000s, the US dollar actually appreciated in trade-weighted terms. With the bulk of Fed rate cuts behind us and the bulk of rate cuts by the ECB, the BoE et al ahead of us, the 1-3month bias for the US dollar is for strength. As such, we target EURUSD at 1.55 over 1 month and 1.47 over 3 months.

ECB Governing Council member Yves Mersch noted yesterday that the ECB has no room to cut interest rates this year. Given Trichet's relatively greater emphasis on downside risks at last week's rates decision, Mersch's statement is surprisingly hawkish and re-affirms the Governing Council's commitment to delivering price stability ahead of growth concerns. Eurozone inflation currently stands at 3.5% and is showing little sign of slowing, though the ECB remains fairly confident that some alleviation in price pressures will materialise later in the year. Markets still expect the ECB to stay hawkish in the medium term but how much yield support the EUR can derive from the central bank's stance remains in question. Markets have already reacted strongly to the G7 statement, whose significant change in tone is a partial reflection of the ECB's concerns over sharp gains in the EUR. In addition, if Eurozone data continues to show more signs of a pronounced economic slowdown, pressure on the ECB for monetary accommodation may grow from lawmakers and industry alike. We remain cautious in chasing EUR strength from currently levels, but weakness in the other economies may also limit downside in the currency. This morning, the tone of Mersch's comments was reinforced by Trichet, who said that anchoring inflation expectations was key.

Both AUD and NZD traded lower on Monday, partly in response to a stronger dollar, partly due to weaker global equity markets, but also due to domestic data pointing to a slowdown in domestic demand. New Zealand retail sales for February were released this morning and fell unexpectedly by 0.7% m/m against versus market expectations of a 0.3% m/m gain. The data was similar to Australian retail sales for February, which was released earlier this month and also fell unexpectedly. Meanwhile, in Australia home loan approvals fell markedly suggesting that either banks are curtailing lending, or that buyers are more reluctant to take on risk at this point. The number of new loans approved for owner occupiers for February slumped by 5.9% m/m following a 3.1% m/m gain in January. Bank lending also declined, with the number of loans to investors falling by 6.1% - the sharpest fall in 4 years. The NZ economy is probably more structurally unsound than Australia, but both countries have similar features, with high consumer debt, an overvalued housing market and relatively large current account deficits. There may be some modest upside in AUDNZD, but we caution that investors are already fairly long the cross. Rather we prefer downside in both NZDUSD and AUDUSD.

The BoC's Business Outlook Survey released yesterday highlighted downside risks to economic developments with firms interviewed by the bank's regional offices signalling concerns over future sales growth and tightening credit conditions. The balance of opinion from future sales growth fell to the lowest level since 2001. Inflation expectations remain contained, with the vast majority of firms still expecting inflation to fall within the Bank of Canada's inflation-control range of 1 to 3 percent. CPI is due on Thursday, while the BoC meet next week - markets are pricing in 42bp of easing. Our economists are looking for a 25bp cut to 2.75% from 3%.