The bipolar nature of the market continued overnight with equities rallying strongly and the dollar also strengthening. EURUSD traded down to a low of 1.5800 from a European session high of 1.5949, while USDJPY traded up to a high of 105.20 from a low of 103.89. The S&P500 rose by 2.5% driven by better than expected earnings for a US bank, which helped to ease fears over the credit crisis. US Treasury yields were also lifted by stronger than expected CPI, and 2-year Treasury yields are up by 4bp, while 10-year yields are up by 8bp. CPI for June rose by an enormous 1.1% m/m, boosted by a 6.6% increase in energy prices, while industrial production rose by 0.5%/ However, on a negative note, the housing market index for July fell to a record low of 16, from 18 in June, based on data going back to 1985. Fed Chairman Bernanke provided a further lift to the dollar by stating that he wouldn't rule out intervention but otherwise his testimony was a repeat of Tuesday's delivery. While Bernanke may be adopting a more dovish/less hawkish tone again, Fed President Hoenig came across as still hawkish. He said that 'while the current accommodative stance of monetary policy reduces the risk of recession, it almost certainly raises the risk of higher inflation.' Looking beyond the rally in the dollar last night, we think the developments concerning Freddie Mac and Fannie Mae warrant a lower trading range for now. As such we still target EURUSD at 1.60 over 1 month and see upside risks to that view. Ahead today, jobless claims are due at 1230 GMT.

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. 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 further tightening in rates is likely. 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.

In figures released yesterday, 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% in numbers released yesterday. We expect the MPC to stick to a neutral path with the emphasis on downside risks.

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.

In a monthly report released on Wednesday, the Bank of Japan lowered its assessment of the Japanese economy, warning that it would slow further on the back of rising energy costs and commodity prices. This comes as no surprise as the BoJ lowered its forecasts for the economy after yesterday's policy meeting. There were bright spots, such as ongoing export growth, and output is seen returning to an upward trend, despite remaining weak. Inflation remains a concern and core CPI is now expected to rise either around 1.5%y/y or at a little higher pace. However, the BoJ did hint yesterday that policy hikes may be considered if policy becomes too loose, but for now the JPY should largely be determined by constant shifts in risk appetite and its underlying drivers. If oil prices are topping out terms-of-trade effects will help the JPY recover, but a recovery in demand is also needed for the economy to rebound. In data released this morning, the Reuters monthly Tankan (which emulates the BoJ quarterly Tankan) showed a further deterioration in July. The manufacturing index in particular fell to -10 in July from -2 in June, while the non-manufacturing index slipped to -3 from -2. BoJ Gov Shirakawa has been steadily downgrading the BoJ's assessment of the economy since taking over, and today's data provides further support to that assessment.

The AUD weakened on the back of comments by RBA Governor Stevens yesterday, in which he warned that it is "more likely now" than two months ago that demand will moderate. Our economists note that ultimately, Stevens suggested that the chances of keeping inflation low over the medium term were good, notwithstanding the risk that inflation expectations could rise if people fear this "temporary period of high inflation, could, in fact, turn out to be persistent". However, even if the next RBA move is likely to be down, under current market conditions, this may not directly translate into a weaker currency. On the international situation, he attributed high inflation rates to excessively accommodative conditions in the EM world, and such policies should continue to fuel demand for resources and in turn, higher resource prices should contribute to slower growth in many industrialised countries. He recognised that taming high commodity prices would require further policy tightening among major developing economies. As such, there is a limit to how high the RBA can adjust rates in the context of imported inflation. Nonetheless, Australia is better positioned than other industrialised countries due to the positive terms-of-trade shock. As such, his comments are supportive of the AUD against G10 FX, since yield differentials in favour of AUD would likely remain wide.