USD/JPY briefly dipped below the 0.8700 level early this morning. If this level gives way, it will be for the first time since the end of last year. The Nikkei lost 2.9% overnight with the impact of yen strength on exporters worrying investors ahead of a three day weekend in Japan. Despite the fact that worries about the pace of the US recovery remain central to the safe haven flows that are principally responsible for yen gains, the S&P managed to close last night a touch higher. These gains, however, can be linked with relief on the Goldman /SEC settlement which is unlikely to sustain the stock market for long. Yesterday’s disappointing readings on both the Philly Fed and Empire manufacturing indices and the weakness in the US industrial production data once the impact of utilities was stripped out will insure that worries about the pace of the US recovery continue to cloud the potential for risk assets.

The outlook for the USD has clearly been impacted by the view that the Fed could ease again before it eventually tightens. Either way fears of Fed tightening have been pushed further back into the middle of next year meaning that there is now little difference between market expectations for the first Fed and ECB rates hikes of the cycle. While US data has been almost all disappointed since the release of the May US payrolls report, this has not been the case in Germany. Confidence in Germany has taken a knock amid concerns about sovereign debt and the health of the European banking sector but industrial production has continued to grow, sucking in labour along the way. Economic and interest rates differentials therefore support this week’s rise in EUR/USD. The EUR has also been boosted by the recent decent result in Spanish debt auctions and the Greece bill sale which have taken the edge off the sovereign debt crisis. That said the results of the EU bank stress tests are now just line week away. If these tests are to be judged credible there must be failures. Insofar as investors are likely to be relatively reluctant to participate in a widescale re-capitalisation of the European banking sector, there are still a number of headwinds that the EUR must face. Poor news on the European banking front is also likely to increase investors demand for safe haven assets. This suggests that gains for the EUR/USD from current levels could be tough. This morning the psychologically important EUR/USD1.300 level has held.

Cable has given back some of its gains though it has held above USD1.5400 this morning. The ongoing debate about inflation in the UK is reflected in the consensus view that BoE rates are likely to rise ahead of those from the Fed. This can be linked with the better tone in cable this week. However, the austerity measures announced by the coalition government does support the view of the BoE’s King that excess capacity in the economy will bear down on inflationary pressure. This suggests that cable’s gains may run out of steam.

The AUD performed poorly overnight in tandem with the soft tone in stock markets. The PM played down speculation that she will call an election for August 28 indicating that nothing had been confirmed. AUD/USD has stabilised above the 0.8750 level during European hours. However, concerns about the growth in Chinese domestic demand continue to hinder the ability of the AUD to climb above USD0.88850.

US CPI this afternoon is likely to highlight benign inflationary pressures. TIC data and Uni of Michigan confidence are also due.