The US dollar strengthened moderately this morning after weakening sharply on Friday. EURUSD traded up to a high of 1.5949 in the US session from a low of 1.5793 and has traded back down to 1.5899 so far this morning. The dollar is set to stay weak given the problems with Freddie Mac and Fannie Mae and Friday's failure of IndyMac - a major Californian mortgage provider and the third-largest US financial institution to fail in US history. Yields in the US are higher on expectation that the government will bailout the two GSEs, with 2-year yields up by 20bp on Friday, while 10-year yields rose by 16bp. Stock markets are also lower, with the S&P500 down by 1.1% and the S&P Financial Index down by 2.6%. Despite all the problems in global markets, oil managed to rise on Friday by 1.94% to close at US$144.41/bbl, but has traded lower again this morning on the back of the dollar recovery.

Comments by Treasury Secretary Paulson this morning have attracted attention. Paulson said that the US Treasury will increase its line of credit to Freddie Mac and Fannie Mae and that the Treasury will have temporary authority to buy equity in either firm if needed. What is most notable about the comments is that the US Treasury is stopping short of nationalising either of the institutions. Nonetheless, the market will remain sceptical that the government won't take full custodianship eventually. Such a development would significantly increase public debt and would be detrimental to US credit ratings. Either way, the uncertainty will likely deter foreign reserve managers from acquiring additional US Treasury and agency debt and keep the dollar on the back foot for now.

In the week ahead, Fed Chairman Bernanke is scheduled to deliver his semi-annual monetary policy testimony on Tuesday and Wednesday. We expect he will strike a fairly similar tone to that of the June 25 FOMC statement. Our US economists continue to call for two rate cuts by year-end in contrast to market expectations, and the latest developments are supportive of their views. There are no major events scheduled for the US session today.

Eurozone data has been consistently weak over the past month but the deterioration is probably not yet severe enough for the ECB to switch tracks. Trichet sounded surprisingly hawkish during last week's testimony to the European parliament and political protestations have once again fallen on deaf ears. In this backdrop, our economists agree that although the risks to growth remain to the downside, Q2 GDP should still post a positive 0.1% q/q. Nevertheless, we expect the ECB to deliver a second rate hike this year, probably in September. Our economists believe that the ECB made it very clear that inflation expectations and wage rounds are a risk for inflation, and that it wants to counter these effects. The July hike should have been enough to achieve this goal, but given the forthcoming increase in inflation, we believe they will hike again before turning to a neutral stance next year, where 75bp in cuts are expected. In the week ahead, CPI and the German ZEW survey are due and a number of ECB officials are scheduled to speak. Hawkish ECB comments and elevated inflation should support EURUSD.

The Canadian economy surprisingly shed jobs in June. In data released on Friday, the unemployment rate increased to 6.2% (cons. 6.1%) as 5k jobs were lost. This is the first decline in jobs since last December and supports the case for the BoC to keep rates on hold, and call into doubt the BoC's hawkish stance. Earlier last week, the Business Outlook Survey from the Bank of Canada (BoC) showed continued strength in the business sector, investment rose sharply and hiring intentions also rose. Importantly, companies become increasingly concerned on pressures on inflation, the BoC said. Inflation expectations exceeded the banks 3% range, signalling that the bank may take this as a sign that rates should not be lowered from here (3%). Although other surveys are solid, our one-month USDCAD forecast at 0.97 may be at risk if the market believes the BoC would need to return to a dovish track.

New Zealand retail sales for May fell by 1.2% m/m against expectations of a 0.1% m/m rise and after a 1.2% m/m rise in April. It was the largest percentage decline since February 2004. On Friday, the REINZ housing survey showed that sales have fallen 42.4% y/y to the lowest level since the series started in January 1992. House prices also fell, with the median house price 2.2% lower from a year earlier. However, the rate of decline in sales was actually slower than the previous month. A separate survey showed average household wealth is also down 1.2% from December as debt levels increase and housing wealth fell. These figures are consistent with a slowdown in the New Zealand economy, accompanied by falling demand. The RBNZ is widely expected to cut rates in September as inflation eases further but the central bank will need to be on the lookout to avoid a hard landing. If the housing market begins to show signs of bottoming out, bringing forward potential cuts will probably not be necessary. Our economists warn that the June quarter CPI due this week is expected to record the largest quarterly increase since the early 1990s, and the RBNZ still needs sufficient evidence of additional slack in the economy and absence of wage pressures.

Consumer confidence released on Friday sank to a record low as inflation begins to weigh on the economy. The Cabinet Office's quarterly consumer sentiment index fell to 32.3 on a seasonally adjusted basis, from 36.5 in March, the lowest since 1982 when the survey began. Although headline and core inflation are both picking up, Friday's data will likely force the BoJ to retain its current bias, where downside growth risks are the overwhelming concern. In other data, May's industrial output was revised a touch lower to 2.8%m/m growth and capacity utilisation index was up 2.2% m/m. Strong capital expenditure will remain supportive for the economy but we continue to doubt the ability of the JPY to extract strength from macro data at present. The BoJ begin their two-day board meeting today.