The US dollar traded higher against the yen but was stable, albeit rocky, against the euro. USDJPY traded from a low of 105.45 up to a high of 107.11, while EURUSD traded in a 1.5782 to 1.5886 range. Equity markets bounced as the short squeeze continued and despite earnings from IT companies and banks coming in decidedly mixed. The equity markets were no doubt given a boost by a further sharp fall in oil prices, which fell by over US$5/bbl to close at US$129.47/bbl. Reports that the US will attend nuclear talks with Iran for the first time no doubts contributes to lower perceptions of geo-political risks over Israel-Iran tensions. Debt markets also seemed to reflect optimism - Treasury yields rose, with the 10-year up 7 bps to 4.00% and the 2-year up 9 bps to 2.50%.

Economic data was supportive of higher yields. Initial jobless claims for the week ended July 12 increased +18k to 366k, well below market expectations for an increase to 380k, vs. revised 348k (prev.346k). The 4-week average was reported at 376.5k and still well short of past recession levels. Also, housing starts for June rose by 9.1% m/m, following the 2.7% m/m decline in May, while building permits rose by 11.6% m/m in June vs.-0.4% in May. However, our economists note that changes to New York City building codes were responsible for the surge, and as such is a one-off blip.

The FX markets have reached a rather confusing juncture. If oil prices continue to decline or stay low, central banks in the G10 will start to conclude that the inflation crisis is passing. In that case, banks such as the ECB will be able to start cutting rates in the coming months in order to deal with slowing growth. However, while a clear risk, we think it is too early to count oil out and would be more confident in the decline in oil prices if it was accompanied by lacklustre stocks as that would clearly imply that falling demand was responsible for lower oil prices. Fluctuations in geopolitical risk premiums or long squeezes in oil accompanied by short squeezes in equity markets do not change the bigger picture. As such we continue to target EURUSD at 1.60 over 1 month reflecting US financial market concerns and elevated Eurozone inflation concerns. We target EURUSD at 1.53 over 3 months once we are more confident that oil's impact on headline inflation is moderating.

Ahead today, Australian terms of trade are due at 0130 GMT; BoJ Governor Shirakawa speaks at 0330 GMT and will take questions. There are no major events of note for the US session.

News wires reported that the EU parliament has drafted a call for the ECB's inflation objective to be shifted upward from the "close to, but below 2% requirement". Any such change would require a change of the Maastricht criteria and is unlikely to happen anytime soon. Current talk signals politicians' unease with rising interest rates. On Wednesday Eurozone HICP inflation was confirmed at 4.0%. Core inflation (ex food,tobacco and energy) came in at 1.8% from 1.7% in May. The pick up in headline HICP (0.4% m/m, prior 0.6%m/m) was again driven by food and energy prices. Looking ahead, we expect inflation to pick up to 4.3% in August, which is one of the reasons behind our call that the ECB will likely raise policy rates in September by 25 bp to 4.5%.On Tuesday, 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. A 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; the IFO will be released next week. Nevertheless, at present the EUR is not displaying a strong sensitivity to downside data and price action remains largely driven by dollar events. However, we still expect the market to converge towards a more hawkish ECB view, despite Trichet's professed "no bias" position, as strengthening core CPI point to further entrenchment of strong inflation expectations.

BoE MPC member Andrew Sentance said that the slowdown in GDP growth so far was not out of line with the May Inflation Report forecast. The tone of the comments was hawkish, but that is hardly surprising given his voting record. According to Sentance, a recession is not the bank's central forecast but it will be very difficult to avoid a significant slowdown; he said 1.3% GDP growth for 2009 is reasonable (UBS at 0.9%). In figures released on Wednesday, the unemployment rate in the UK dipped to 5.2% according to the ILO, but the claimant count jumped by 15.5k (cons. 10k), the biggest rise since December 1992. However, earnings growth eased in May, registering 3.8% y/y headline growth (3.9% prev., cons. 3.7%) and the ex-bonus figure was also softer at 3.8% (3.9% prev., cons. 3.8%). The figures also show the lowest number of vacancies since February 2007 and the weakest productivity rate since Q3 2005. The deterioration in labour markets will be troubling but with the economy already slowing down, such declines are within expectations. Slowing wage growth may ease fears of second-round effects taking hold in the UK, despite inflation hitting 3.8%. We expect the MPC to stick to a neutral path with the emphasis on downside risks. Short GBP positions are significant already. We are tactically long GBP against the EUR from 0.7917, targeting 0.7200.

The BoC Monetary Policy Report underlined the bank's neutral outlook on rates. While short-term risks for inflation stay, the CPI is projected to converge with the core rate of inflation at the 2% target in H2 2009. GDP growth has been revised lower to 1% in 2008, 2.3% in 2009 and 3.3% in 2010. The central bank judges that the current policy rate at 3% remains appropriate. In a separate report, at C$10,717 bn securities flows surprised market consensus (C$3,500 bn) while topping previous results of C$9,751 bn. Foreign demand for Canadian bonds accelerated. Foreigners acquired long-term debt instruments issued by the provincial and corporate sector. Non-residents purchased C$7.7bn, the largest monthly acquisition in over a year. Non-residents also added smaller amounts of outstanding Canadian bonds and money market instrument to their portfolios in May, Statistics Canada said. Canadian investors continued to diversify their short-term foreign investment, buying foreign stocks and foreign short-term debt. While this may signal a pick-up in risk appetite, it was not enough to compensate the inflow of capital. We believe that USDCAD should stay in its 0.97-1.02 range for now.

The Riksbank published the minutes to its July policy meeting yesterday. Although the decision was unanimous, sharp divisions emerged over the forecasts detailed in the policy outlook in the July Monetary Policy Report. The MPR itself was surprisingly hawkish but three out of the six board members disagreed with the forecasts, and our economists note that it is clear Governor Ingves used his casting vote to impose the official profiles presented in the MPR. We have argued in the past that the present profile may result in a significant overshooting in tightening and is not justified by Swedish fundamentals. However, the latest inflation reports for June remain elevated and a further hike is likely. However, two more hikes from present levels look unlikely at this stage. Yesterday's release will temper rate expectations for Sweden, further pressuring SEK at a time when risk aversion and growth worries are already weighing on the currency. Our current 1/3m forecast for EURSEK stays at 9.35 and 9.25, respectively.

Merchandise imports for June were released yesterday and registered a drop of 2% m/m. Based on the data, our economists look for a modest trade surplus of A$300 mn, which would be larger if not for disruptions to mining resulting from a gas plant explosion in Western Australia. Domestic demand in Australia is undeniably slowing and today's data is supportive of that view. Moreover, the tone of RBA Governor Stevens' speech on Wednesday is consistent with the RBA leaving rates on hold this and potentially cutting rates next year. Commodity prices have been coming off quite sharply since late June. These factors will temper gains in AUD for now. However, the potential for significant AUD losses appear limited given the extent of Chinese interest to invest in Australia. We target AUDUSD at 0.97 over 1 month and 0.9300 over 3 months.