USD

The US dollar weakened sharply overnight with EURUSD trading up to a high of 1.5754 from a low of 1.5621, while USDJPY traded down to a low of 106.71 from a high of 107.75. Risk aversion shifted higher, with a research report arguing that Freddie Mac and Fannie Mae require more capital, sending their stocks down by 20% during the session. Oil prices seem to have been affected by deteriorating growth sentiment, and fell by US$3.60/bbl to close at US$141.64/bbl. Meanwhile, US 2-year Treasury yields fell by 8bp and 10-year yields fell by 6bp. Fed's Yellen spoke overnight and said that "by early next year, ... I expect that assuming commodity prices level off, core as well as headline will moderate, as more slack in labour and product markets emerges". She characterised inflation expectations as "reasonably well anchored". Market attention will also be on the G8 Summit, which began in Hokkaido yesterday. G8 leaders have continuously stressed the need for action on rising food and energy prices. However, as the recent OPEC summit has shown, any short-term solution is likely to be met with scepticism by markets, and fundamental concerns over supply constraints and geopolitical instability remain. Central bankers will not be present at the meeting and we are not expecting any policy initiatives. A more likely catalyst for weaker oil prices will be a clear sign of weaker global demand resulting from disappointing growth in the key G10 economies. Our US economists note that the disinflationary effect of increasing slack in the economy will ultimately prevail over the inflation-boosting impact of higher commodity prices and dollar depreciation. The same effects are likely to be seen in the Eurozone. At current oil prices, Eurozone inflation will also face continuing upside risks. A vigilant ECB will support the euro, as currency sentiment remains largely yield-driven. We only see EURUSD easing on a three-month basis as a marked downturn in growth forces the ECB onto a more dovish track. Nevertheless, this may be delayed if any corresponding drop in demand fails to adversely affect oil prices. We are currently long a 3m EUR put (initiated June 16) with a strike at 1.51.

Ahead today, Fed Chairman Bernanke speaks at 1200 GMT. The pending home sales index is due at 1400 GMT.

JPY

BoJ Governor Shirakawa spoke yesterday and kept to a familiar script. He said that global inflationary risks were intensifying but said that Japan's economy was slowing on high energy and raw material prices. He said that Japan will likely return to moderate growth after a slowdown. The data flow is limited for the week but the G8 summit due to be held between July 7 and July 9 in Hokkaido will attract market attention. High energy and commodity prices will be in focus but with central bankers absent, though specific agreements targeted at lowering energy prices may have an effect on oil prices. In Japan itself, industrial production and core machinery orders are the key releases for the week. Output is still expected to show declines as global demand begins to soften. The trade balance is also due and the market is expecting a decline to JPY 500bn.

EUR

German industrial output for May fell by 2.5% m/m, well below market expectations of a rise of 0.4% m/m, and follows on from the 0.8% m/m decline in April. The data supports our view that Q2 GDP will likely be very weak, probably in negative territory. Meanwhile, ECB President Trichet spoke at an economics conference in France over the weekend and stuck to his comments from last Thursday's ECB meeting. He delivered another passionate defence of the ECB's mandate and warned that price stability remains the ECB's current position.

GBP

UK manufacturing output fell by 0.5% m/m in May, much weaker than expectations of a -0.1% drop (prior +0.2%). Industrial output fell 0.8% vs. expectations of a -0.1% print (prior +0.1%), raising fears that economic activity is slowing at a much faster pace than originally anticipated. Multiple sectors of the UK economy are showing signs of a significant slowdown and this further complicating policymaking for the BoE. Nationwide and DCLG House Prices indices due this week will likely point to further deterioration on the consumer side as wealth effects take hold The BoE decision on Thursday will be the highlight of the week. Despite rising inflation numbers having triggered a Governor's letter to the Treasury, the current outlook on growth should keep the BoE on hold at 5.0%. Despite ongoing expectations of an upside move up ahead, we continue to expect the next move to be down, but not until May next year.

CHF

At 2.3% (previous: 2.5%), the unadjusted unemployment rate was released inline with market expectations. This is the lowest reading since 2002, suggesting that consumer spending remains an upside risk to economic activity. SNB Governing Board Member Thomas Jordan said on Monday, that an unchanged monetary policy is sufficient in order to bring inflation back to price stability, while growth risks on the downside. He added that Switzerland is not immune against deteriorating global growth conditions. Going forward, our economists remain of the view that the SNB will tighten in September. In its last monetary assessment the central bank highlighted that inflation is regarded to be of temporary nature, as they are highly impacted by energy prices only, which are not expected to remain at high levels. Also note, the US corporate earnings season starts today, and any disappointments should keep CHF in demand.

AUD

The key data release in Australia this week is employment for June due on Thursday, with the market expecting a 10k rise, following a surprise 19.7k decline recorded in May. The nature of employment data is that if hiring doesn't take place in month, and if underlying trend growth in employment remains firm, then a backlog of hiring likely builds up. As such, the data tends to 'bounce' following a decline and if it doesn't and we record a second-consecutive month of declines, then it likely signals a change in trend in the underlying series. AUD has been the odd currency out with its strength among those currencies backed by current account deficits, owing in part due to high levels of job security. Any deterioration in employment would have a significant impact on household consumption and hence significantly change market expectations on the RBA rate outlook. Of course the other reason why AUD has been held afloat is investor interest in its mining sector. The government is presently deliberating on making changes to the foreign investment rules to make it more difficult for sovereign wealth funds to take controlling stakes in mines. This comes after revelations that since the Labor government came to power in November, the country has received around A$30bn in China investment applications. By comparison Australia received less than A$10bn in investment applications by Chinese investors in the FY2006 and FY2007. We continue to target AUDUSD at 0.97 and 0.95 over 1 and 3 months.

CAD

The Business Outlook Survey from the Bank of Canada (BoC) was the first highlight of the week. While a narrow focused survey, our economists still think that it is an important information source for the BoC. Surprisingly, the results from the summer survey did not suggest widespread weakness across Canadian firms; rather the opposite held true. Activity remains strong, investment rose sharply and hiring intentions also rose. Importantly, companies have become increasingly concerned on pressures on inflation, the BoC said. Inflation expectations exceeding the bank's 3% range rose sharply, suggesting the bank may take this as a sign that rates should not be lowered from here (3%). The outlook's positive results offered little news to the market, which expects rates to be unchanged for now. Looking ahead, June payrolls are due on Friday. We are keeping our one- and three-month forecasts at 0.97 and 1.03, respectively.