The dollar strengthened significantly overnight helped by a further decline in oil prices and hawkish Fed comments. EURUSD fell from a US session high of 1.5945 to 1.5758, while USDJPY traded up to a high of 107.45 from a low of 106.05. Oil traded lower by US$2.62/bbl to US$128.42 with little apparent justification. Equity markets rose despite disappointing earnings, while Treasury yields finished higher. Fed's Plosser was hawkish warning that the inflation-adjusted Fed funds rate was now negative. On rates he said that "We will need to reverse course - the exact timing depends on how the economy evolves, but I anticipate the reversal will need to be started sooner rather than later. And I believe it will likely need to begin before either the labor market or the financial markets have completely turned around." Many other regional Fed presidents have been hawkish recently, notably Fisher, Hoenig, Lacker and Stern contrasting with Fed Chairman Bernanke who has indicated increased concern over growth since the June FOMC meeting. Over this week, we expect the upside in EURUSD to be capped for now, with this week's Ifo business climate survey release on Thursday of heightened relevance to ECB rate expectations up ahead. We expect the survey to undershoot market expectations and such an outcome will weigh heavy on the pair. Ahead today, the Fed's Beige Book is due at 1800 GMT and is unlikely to show an improvement in key districts.

The yen has underperformed the Swiss franc since late May despite both currencies sharing similar risk aversion properties. We would attribute the underperformance to the yen acting as a beta on general Asian currency moves, with most of Asia underperforming due to concerns over excessively high inflation. Competitor currencies such as the KRW have weakened significantly and this in turn puts pressure on the yen to weaken owing to a deterioration in its relative competitiveness. Oil has also helped to undermine the yen, not only due to the negative terms of trade effects, but also via its effect on relative policy expectations. Put simply, the markets have rightly judged that the ECB is much more likely to lift rates in response to high oil prices. In turn if oil prices were to fall sharply, the ECB is more likely to cut rates significantly as well as inflation pressures ease. Japan's economy remains extraordinarily stable and the policy changes of the BoJ stem primarily from watching the international environment. There are a couple of positive news stories floating around. Finance Minister Nukaga has been touring the Middle Eastern region to promote Japan as an investment destination for sovereign wealth funds. This makes sense as Middle Eastern investors have been over exposed to the US dollar and need to diversify. Also, we frequently get asked for updates as to whether the government will allow tax exemptions on un-repatriated profits for FY2009. Japan has Y17.2 tn in un-repatriated profits and we estimate around a third would head home in the event that they were tax-exempted. However, any further discussion on this front would likely take place at year-end in preparation for the next fiscal year, which begins in April. Keeping this in mind, we continue to target USDJPY at 105 over 1 and 3 months.

Italian consumer confidence for July fell to 95.8, its lowest level in nearly 15 years, and down from 100 in June and disappointed consensus of 99.10. Major weakness was registered in the forward looking "Future Climate Sub Index", which fell to 88.4 from 97.6 in June, adding to concerns over deteriorating growth conditions in the Eurozone. We expect investors to shift their focus now to this week's German Ifo release, and any below consensus reading will weigh heavy on EUR. While the German economy acted as a counterweight to worsening conditions in the rest of the union, a weaker growth outlook will complicate the ECB's stance on monetary policy up ahead, especially in a scenario of decreasing inflation expectations. According to our own measures medium-term inflation expectations reached a multi-week low, a development which is also confirmed by ECB members. Overnight, ECB Executive Board member Bini Smaghi said that inflation expectations have started to decrease, and that a recovery in the Eurozone may take longer than forecasted by the central bank. However, he also outlined that the ECB's key rate at 4.25% is not exactly restrictive with inflation at 4%. Looking ahead we expect EURUSD to remain capped to the upside for now, with this week's Ifo business climate survey opening up downside risks.

The trade balance for June reached a new record surplus of CHF2.412 bn, up from CHF1.874 bn in May. Nevertheless export growth continued to weaken, and in real terms fell by 3.5% on the year. While such conditions should weigh on price pressures up ahead, the most recent reading on producer prices, released on July 21, was released above expectations, supporting concerns over price stability to be at risk. Our economists continue to expect the SNB to tighten rates at their next policy meeting. Going forward, we expect risk sentiment to remain the franc's key driver for now, and our risk index has reached the lowest level in more than six weeks. Under such conditions we expect the franc to remain capped to the upside.