The dollar continued to strengthen overnight as global growth expectations waned further and commodity currencies and commodities were hit hard. EURUSD traded down to a low of 1.5545 from a high of 1.5495 while AUDUSD fell more sharply, and traded down to a low of 0.9132 from a 0.9196 and a far cry from the 0.9500 levels of last week. More spectacularly, oil closed the US session at US$118.58/bbl, down US$2.83 on the prior session and is now down US$28.69/bbl from its all-time highs of US$147.27 reached on July 11.

The FOMC kept rates unchanged as was expected and the accompanying statement suggested that their view on the US economy was stabilising. For instance in the June statement, the FOMC wrote: "Although downside risks to growth remain, they appear to have diminished somewhat, and the upside risks to inflation and inflation expectations have increased." While in the August statement, the FOMC wrote: "Although downside risks to growth remain, the upside risks to inflation are also of significant concern to the Committee." In the August statement, the FOMC also indirectly notes that oil is no longer rising by stating: "Inflation has been high, spurred by the earlier increases in the prices of energy". With downside risks to growth balancing upside risks to inflation and their view on the economy stabilising, there is less scope for policy activism by the Fed. Nonetheless, our economists still believe the Fed will be forced to cut rates by year-end on the back of a further deterioration in the economy - i.e. they err on the side that downside risks to growth will materialise. There are no major events scheduled in the US session today.

The main event this week remains the ECB President Trichet's press conference tomorrow following the ECB rate decision. While we expect the ECB to keep rates on hold, it will be interesting to see what he makes of the decline in oil prices combined with evidence of a weakening Eurozone economy and its implications for the Eurozone inflation outlook. If he shows any of the flexibility that the RBA has shown in its view over the past week, then there are further downside risks EURUSD in the near term.

Eurozone service PMIs for July showed contractions across the currency union apart from Germany. Italian PMI came in at 45.6 (cons. 47.3), France at 47.5 (cons. 47.0) and the Eurozone print was 48.3. Of far greater concern were retail sales, which declined sharply to register -3.1%y/y (cons. -1.3%y/y). Our economists now estimate the probability of a recession in the euro area at 35%. Weakening activity data and softer commodity prices continue to weigh on falling rate expectations which are currently hurting the EUR. On Monday, the IMF announced estimates which showed the Eurozone's inflation rate will not fall below the ECB's 2% target until the end of 2009, and several members of the IMF's executive board noted that the ECB should consider hiking rates again if inflation remains at stubborn levels. The ECB has indicated to some extent that further moves cannot be ruled out, but economic indicators have deteriorated across the Eurozone more rapidly than anticipated. Thursday's press conference held by ECB president Trichet remains the highlight of the week and we expect at least some indication of willingness to consider easing. This did occur in Q2 when a sharp drop in the April Ifo reading forced the ECB on the back foot but an immediate rebound and a surge in energy prices allowed a return to a hawkish track. The same justification cannot be utilised under current circumstances and the ECB decision may weigh on the EUR as a result.

UK Industrial Production and Manufacturing production for June disappointed again. Industrial output fell by 1.6%y/y (cons. -1.2%) and manufacturing production by 1.3%y/y (cons. -0.6%y/y). This is the third consecutive month of contraction and our economists believe that outlook for the sector remains grim, with the forward-looking new business balance hitting a series low. Meanwhile, the inflationary concerns in the report were evident: the input price component eased but remains elevate at 70.2. Oil prices were the main driver of the price pressures but recent falls in energy and commodity prices will be taken into account at this week's BoE meeting. Our economists believe the MPC will remain on hold due to inflationary concerns, despite other indicators already in recessionary territory. EURGBP remains range-bound ahead of the meeting, but we expect a combination of BoE stability but a more dovish outlook from the ECB to weigh on the cross, which we remain short as a trade recommendation. In other data released overnight, PMI services came in at 47.4, not as bad as consensus expectations of 46.6 but still pointing to further weakness in the economy. With the manufacturing sector already contracting no offsetting forces will be available from the key service front.

The RBA kept rates on hold at their board meeting yesterday as was expected, and the accompanying statement signalled that the bank could ease rates in the coming months. The RBA noted that it had been attempting to suppress demand to cope with inflation and that it seems that demand is currently being retrained by tighter financial conditions, higher fuel prices and lower asset values. As such the bank said that "there was scope to move towards a less restrictive stance of monetary policy in the period ahead." However, the market had already been pricing in 39bp of easing by the RBA heading into the statement and as such the RBA's tone was not or should not have been too much of a surprise. Indeed, the statement is more an evolution of the RBA's earlier in statement alongside evidence that domestic demand has softened further in Australia. Our economists now expect the bank to cut rates by 25bp in September and this is now fully priced in by the rate markets. We understand that AUD should remain under pressure against the US dollar in the context of a slowing domestic economy and concerns over the global economy. However, at the same time, China policymakers are emphasising supporting growth over containing inflation, and FDI from China should be supportive of AUD. As such we don't believe the currency will fall out of bed. We do take the opportunity to revise lower our AUD forecasts however, and now target the pair at 0.9500 over 1 month and 0.9300 over 3 months, down from 0.97 and 0.95 previously. Our new 1-month forecast implies that AUD has been oversold for now. We also lower our 1-month AUDNZD forecast to 1.30 from 1.31, while leaving our 3-month forecast for AUDNZD at 1.33. This leaves our 1 and 3-month forecasts for NZDUSD at 0.73 and 0.70 respectively, down from 0.7400 and 0.7150.

Taro Aso, the new Secretary General of the LDP said yesterday that the Japanese economy is in a slowdown, and acknowledged that it would be hard to meet the government's target of achieving primary balance in 2011/2012. Aso has been seen as one of the clear winners from the recent cabinet reshuffle by Prime Minister Yasuo Fukuda, returning to a top cabinet position after losing the leadership vote after Shinzo Abe's resignation. The comments come on the back of increased discussions over plans to hike the consumption tax to boost the country's fiscal position, but debate is likely to be prolonged and action over a two-year horizon has been mentioned on multiple occasions. Domestic fundamentals are unlikely to be supportive for the JPY in the short term but we remain on the lookout for abrupt episodes of risk aversion.