There was a clear common thread in last night's words of Fed Chairman Bernanke and the minutes of the July BoE MPC published just a few hours before. The majority of Fed members see the risks to US growth as weighted to the downside. The MPC concluded that the prospects for UK GDP growth had probably deteriorated a little over the month. In line with this thinking both the Fed and the MPC have left open the prospect that further stimulus could be taken if it were considered necessary.

The acknowledgment that the easing cycle may not be over yet in either the UK or the US is a strong contrast to the expectations that existed earlier this year. In the first few months of this year, many investors were expecting the Fed to hike before the end of 2010, fears that the BoE could hike this year persisted even longer; it will take further fall in UK headline inflation to completely put to bed these fears.

Echoing the sentiments of the Fed, US interbank rates have edged lower since the start of this month while UK rates have been largely flat. In contrast Euribor has been bias higher. While ECB Governor Trichet recently attributed the tightening in conditions as being a function of market forces, the firmer stance of Euribor and the withdrawal of liquidity is consistent with the ECB's program of policy normalisation. These slightly tighter conditions can be defended by the relatively better position of German economic data in recent weeks.

Where US data have disappointed there has been increased evidence that the recovery in Germany's manufacturing base and employment markets continues. This morning's release of German July manufacturing PMI brought a much stronger than expected jump to 61.2. There have also been signs of some moderation in the concerns surrounding sovereign default risks concerning Spain, Greece and Portugal; though these fears will continue to haunt the Eurozone for some time yet.

The firmer position of Euribor and the moderation in concerns over sovereign default explain why EUR/USD recently recovered back to USD1.300. Bernanke's words last night do not fundamentally alter the message derived by the FOMC minutes that were published in the middle of last week although yesterday's dovish tone did undermine equity markets creating a knee-jerk push into safe haven assets including the USD. Continued divergence between US and EUR money market rates is encouraged by the sentiments of Bernanke and it does suggest that the recent process of short-covering in EUR/USD may not be over; although the results of the EU bank stress tests may be a more overwhelming near-term influence. EUR/USD has pushed higher in London hours this morning as various European banks, including one or two in Greece and Portugal, expressed confidence about their performances in the EU stress tests.

The results of these tests are not due to be published until 16:00 GMT tomorrow, although there is some pressure to bring forward the publication. While the EUR may rise further near-term on the impression that most banks have probably passed, this factor may return to undermine the EUR if the credibility of the tests cannot be proved. Medium-term, the potential headwinds facing the Eurozone are such that we remain unconvinced that the EUR's fortunes have turned vs the USD.

Sterling strengthened on the back of stronger than expected retail sales data this morning (+1.3% y/y in June). Sales were driven by an increase in sales at electrical stores. This hints that there may be a 'world cup' effect in these data which may peter out particularly as the economy moves into the post-budget environment. The gains for the pound ran out at the EUR/GBP0.8390 area and above USD1.5280. As long as cable hold above trendline support at USD1.5140, its bias remains higher. Sterling may find further support in tomorrow's release of Q2 GDP data. While Q2 is generally expected to be relatively robust, impact may be muted by concerns about the performance of H2.

The tone of the AUD, NZD and CAD improved in the European morning as risk appetite improved in tandem with the EUR.

US retail sales and Canadian retail sales are due this afternoon.

Jane Foley

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