The two-tier global recovery has been a major theme for markets in recent years. However, as central banks in the West keep rates low to try and stimulate activity, Asian central banks are preparing to hike rates to combat inflation, which has pushed some Asian currencies to 14-year highs.

Inflation may be the chief economic threat in the East, but in the West the Eurozone sovereign crisis and the US debt ceiling threaten the world's major economies with deflation. Unless a major event like a US or European default actually occurs, which would threaten the global economy, this inflation/ deflation theme is likely to play out for some time.

Australia is firmly in the Asian camp after price data released overnight for the second quarter was stronger than expected. The trimmed mean inflation data, which is looked at by the RBA, rose by a higher than expected 0.9% in the second quarter, which pushed the annual rate to 2.7% from 2.3% in the first quarter. This has pushed up Aussie interest rate futures, which measure interest rate expectations. The 3-month future rose 10 basis points in the aftermath of the report. This has also boosted the Aussie, which broke to fresh record highs today and is currently trading around 1.1070.

The RBA meets next week and it will be interesting to hear what it makes of the price data. Governor Stevens said earlier this week that there are some advantages to a strong Aussie, and we would expect the Committee to stick to this line and continue to talk up the currency as this may dampen inflation pressure.

The pacific currencies have been some of the best performers in recent weeks, and this is likely to continue in our view. Although some of the reason for the Aussie and the Kiwi's outperformance is due to the weak dollar, they are also being driven by strong economic fundamentals, inflation pressures and interest rate differentials.

The fight between Republicans and Democrats over raising the debt ceiling and lowering public sector spending continues to rumble on in Washington. Neither side looks like they are close to a breakthrough. Although the US will hit its debt ceiling on August 2, this doesn't mean that the US will automatically default. The US collects over $1 trillion each year in tax revenues, and with interest payments on its debt totalling roughly $20 billion a month, the US can afford to pay its creditors.

Although fears of a default are overdone, the effects of failing to raise the debt ceiling could be enormous as it would likely hit the public sector. Government shut-downs and the failure to pay support payments could dent consumer confidence and weigh on growth, which is already starting to look shaky for 2011. Added to this, there are signs that money market funds are stock piling cash, and banks are less willing to lend to each other in case a solution is not found. Thus, the impasse on Capitol Hill could have very severe economic and financial consequences.

Although Treasury yields have started to move higher, they remain at low rates and a debt auction yesterday was well-received. This crisis is still being played out in the currency markets and the dollar has been sold off this week without much respite. The safe havens along with the Aussie and the Kiwi remain at extreme levels versus the greenback, but the pound and the euro are also well supported against the dollar.

Gold continues to climb to fresh highs; it surged above $1,620 today. There are many arguments that suggest it is not in a bubble, including financial markets stresses, a weak dollar and inflation fears, which may support the gold price in the medium-term. However, it may come under some selling pressure if a solution is found by Washington in the coming days.

In Europe an ECB official stated that price pressures are still a concern and interest rates are still low, however, this was counteracted by money supply data. Growth in Europe's money supply fell to 2.1% on an annual basis from 2.4% in May. This suggests that underlying inflation pressures remain weak. So far German CPI data from the regions has been mixed to slightly higher in July. Ahead today ECB board member Gonzalez-Paramo speaks at 2000 BST/ 1500 ET.

USDJPY continued to trade lower overnight. Reports suggest that Japanese policy makers are considering intervening in the FX markets unilaterally to stem the appreciation of its currency. It is unlikely that intervention would start until after the August 2 US debt ceiling deadline, intervention before then could be futile due to the extreme anti-dollar sentiment pervading the markets.

The Swissie remains supported across the board. There is some major economic data out of Switzerland over the next week including the KOF lead indicator today and PMI and retail sales next week. However, we continue to think the franc will be driven by its safe haven status until there is a resolution to the debt crisis.

Stocks are lower again today after closing yesterday relatively flat. Good earnings data have boosted stocks even as macro and political issues continue to rage in the background.

Ahead today watch out for US durable goods orders, the Fed's Beige Book and more German inflation data.

Data Watch:
Switzerland 10:30BST (0530 ET) KOF Swiss Leading Indicator (Jul) index 1.98 2.23 2.11
United States 1330BST (0830 ET) Durable goods, MoM EXP 0.3%, ex-transport: 0.5%,cap goods orders non-defence ex air: 1%,
United States 19:00BST (1400 ET) Fed's Beige Book
New Zealand 22:00BST (1700 ET) RBNZ Official Cash Rate % 2.50% 2.50% 2.50%

Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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