EURUSD traded to a high 1.6040 early in the European session but came back down to a low of 1.5865 in the US, while USDJPY traded steadily down to a low of 104.16 from a European session high of 105.94 as risk aversion rose. Oil didn't take too kindly to Fed Chairman Bernanke's concerns about growth and closed down US$6.30 to US$138.85/bbl. Risk aversion set in and the Vix index rose to a high of 30.81, before settling at a still elevated 28.54. US 2-year Treasury yields fell by 8bp and the OIS markets are pricing in 11.5 bp of Fed tightening by year-end.

In his testimony to the Senate Banking Committee, Bernanke said that he saw 'significant downside risks' to the outlook for growth, but said that upside risks to inflation have intensified. He said that a top priority for the Fed was to help financial markets and institutions return to normal.

Treasury Secretary Paulson explained his rationale for not putting an upper limit on potential Treasury support for Freddie Mac and Fannie Mae. He argued that having no limit on the credit line would mean that it would be less likely to be used in the first place. Meanwhile, producer prices data underlined the growth versus inflation concern that complicate Fed policy. Producer prices for June rose by 1.8% m/m exceeding market expectations for a +1.3% m/m gain.

Still relatively high oil prices and the Fed's concern over growth will likely keep EURUSD elevated for now. We continue to target EURUSD at 1.60 over 1 month and see upside risks to that forecast. Over 3-months, however, we expect growth concerns in the Eurozone to trigger reversal of dollar weakness and target EURUSD at 1.52.

Ahead today, RBA Governor Stevens speaks at 0305 GMT, Eurozone CPI is due at 0900 GMT and US CPI at 1230 GMT. Bernanke also delivers his second testimony, although his prepared comments will likely be a repeat of last night.

The German ZEW index for July fell to -63.9, well below expectations of -55 and the June result of -52.4 and is at an historic low. Our economists note that the strong drop in morale among analysts is no surprise as it is becoming clear that Germany which has been a stronghold of growth in the Eurozone is now experiencing a sharp slowdown as well. Although macro data weakened considerably in the last few weeks, the ECB has been gradually shifting its rhetoric towards a hawkish bias since their July policy meeting, and on the back of increasing inflation expectations a further tightening in rates is likely. Going forward, there will be a strong focus on today's CPI release, and its outcome will most likely have a strong impact on rate expectations up ahead. Elsewhere, European Commission President Barroso said that the euro has been a good cushion against inflationary pressures. In an environment of further rising oil prices policymakers will likely be reluctant to call for a weaker currency.

CPI for June rose by 3.8% y/y versus consensus of 3.6% y/y. The positive surprise was primarily due to food and transport costs. Core inflation also edged higher to 1.6% y/y from 1.5% y/y previously and will likely raise fears of second-round effects. However, we do not see the BoE in a position to react against increasing price pressures in an environment where downside risks to growth are steadily rising. In that respect BOE Governor King warned that there is a "very clear risk" that the U.K. economy will slow so sharply that the annual inflation rate may fall below 2% over the medium term. Comments from MPC member Barker also warned that the BoE must be careful not to keep rates too high for too long, which could result in a sharper than necessary slowdown. As the BoE is clearly sticking to a more dovish stance up ahead and it remains the only central bank in Europe where a hike is not expected by our economists. We remain cautious on the currency and expect EURGBP at 0.80 in 1m.

The BoC left rates unchanged at 3%, as expected, and delivered a fairly neutral outlook. It sees overall inflation rising above the 1%-3% target range in Q1, with core inflation remaining at 1.5%, however. The bank's stable outlook on core inflation is important for its near-term rate view. Overall inflation is expected to converge towards 2% in the latter half of 2009. The BoC revised its 2008 GDP outlook to 1% from 1.4%, and marginally revised its growth profile for 2009 to 2.3% from 2.4%. Interest rate developments favor CAD longs but risks of a further selloff in oil would be no help to the loonie. While we maintain our near-term bullish CAD profile, we see no reason for USDCAD to leave its 0.97-1.02 range for now.

The Bank of Japan kept rates on hold at the conclusion of their board meeting on Tuesday. More interestingly, the BoJ revealed updated forecasts as part of its mid-year assessment. The BoJ revised lower its FY08 real GDP forecast to 1.2% from 1.5% and revised up FY08 core CPI forecast to 1.8% from 1.1%. However, the bank expects CPI inflation to moderate to 1.1% in FY09, up from earlier estimates of 1.0%, while GDP is likely to be weaker at 1.5%, down from earlier estimates of 1.7%. Given the anaemic growth prospects for FY2009 it is unlikely that the BoJ would envisage the rise in oil prices sparking runaway inflation. Accordingly, we continue to forecast the BoJ keeping rates on hold for the remainder of the year. This leaves yen a function of global risk appetite. The yen will likely under-perform CHF however, as weaker regional Asian currencies and high oil prices keep the yen under relative pressure. We target USDJPY at 105 over 1 and 3 months.

RBA minutes to the July meeting were released yesterday and showed the RBA shifting closer to a neutral stance. The RBA noted that GDP in y/y terms had slowed and that consumption was slowing. The minutes said that "members concurred that the evidence becoming available in the latest month had added weight to the view that the current stance of policy, in conjunction with the more general tightening in financial conditions that had occurred since the middle of last year&.were working to restrain demand." Of course Australian data since the RBA meeting would likely have clouded the issues once more. Both retail sales and employment released after the RBA meeting bounced strongly and as such the RBA may well be a bit more hawkish than what the minutes would suggest. The AUD continues to outperform the CAD and the NZD, not just due to the RBA but also due to Chinese investment interest in Australia. Since November last year, the Australian government has received A$30bn in investment applications from Chinese companies, which marks a massive surge on previous years. The latest reports on that front is that a major Chinese bank is looking for alliances with Australian banks (reported by the Herald Sun). Such developments will likely keep AUD supported. Meanwhile, in NZ, CPI for Q2 was released this morning and rose by 1.6% q/q, beating market expectations of a rise of 1.4% q/q. In y/y terms Q2 CPI grew by 4% y/y versus consensus of 3.8% y/y. However, most of the positive surprise appeared to come from petrol, with non-tradeables inflation growing by 0.9% q/q, matching the RBNZ's own projections. NZDUSD initially traded higher on the headline print, but reversed the move once details on the breakdown were digested. We expect NZD will remain weak in line with a slowing domestic economy. Ahead today, RBA Governor Stevens speaks at 0305 GMT.