Tough talk from Bernanke and Paulson aid the USD's spectacular reversal back to strength. US 2-year rates scream higher.

Confused market buffeted by one surprise after another. Bank of Canada on tap later with expected 25 bps cut.

MAJOR HEADLINES – PREVIOUS SESSION

• UK May BRC Sales Monitor showed same store sales rising 1.9% YoY.
• UK May RICS House Price Balance rose slightly to -92.9% from -94.7% in Apr.
• Japan Apr. Machine Orders rose +0.5% YoY vs. -1.7% expected
• Australia Apr. Home Loans fell -3.0% vs. -2.0% expected
• Australia Apr. Investment Lending rose 1.4% after a -7.9% drop in Mar.
• Australia May NAB Business Confidence rose to -4 from -8

THEMES TO WATCH – UPCOMING SESSION
Key Risk Events (All times in GMT)

• France Apr. Industrial and Manufacturing Production (0645)
• Sweden May CPI (0730)
• Sweden Apr. Industrial Production and Orders (0730)
• Norway May CPI (0800)
• UK Apr. Manufacturing and Industrial Production (0830)
• UK Apr. DCLG House Prices (0830)
• UK BOE's King to speak (1100)
• US Fed's Fisher to Speak about Monetary Policy (1200)
• Canada Apr. International Merchandise Trade (1230)
• US Apr. Trade Balance (1230)
• Canada Bank of Canada Interest Rate Decision (1300)
• US Treasury Secretary Paulson to speak (1400)
• US Treasury's McCormick to give pre-g8 Press Conference (1600)
• US Weekly ABC Consumer Confidence (2100)
• UK May NIESR GDP Estimate (2301)
• Japan Q1 Final GDP estimate (2350)
• Japan May Domestic CGPI (2350)
• Japan Apr. Current Account (2350)
• Australia Jun Westpac Consumer Confidence (0030)

Market Comments

The market is clearly confused and nervous in recent days with these enormous and volatile direction changes. Before last Thursday, it appeared we were building a strong case for a strong USD, especially with the first supportive rhetoric for the USD from the Fed in recent years, an oil sell-off and the tendency for European data to disappoint of late. Then we got Trichet's ultra-hawkish press conference and an apparent preparation for rate hikes as soon as next month on Thursday. The two-day, 16-dollar rocket ride in oil prices also unnerved all markets and the near-record jump in the unemployment rate from the US on Friday added insult to injury to the USD. The fresh USD longs were sent tumbling to the exits and new USD shorts were emboldened. Yet with the action yesterday and overnight, the market seems to have overreacted in the opposite direction, as a consolidation turned into a rout. The move stronger was boosted by Bernanke talking up the economy's prospects and inflation fighting and Treasure Secretary Paulson stating that he would never rule out intervention to support the USD. (A side thought on that note: considering the paltry US reserves, I suppose Mr. Paulson would need to print some money to use for any intervention...?).

With EURUSD having moved up almost 500 pips and then down nearly 300 pips in less than a week of trading, the bodies of both bulls and bears are strewn all over the trading battlefield. We were fooled along with the market and now try to take a step back and see what unfolds next. The scenario we cooked up in the wake of Friday's events was a quick, strong EURUSD rally to new all-time highs due to the ECB's promise to tighten. Our strong conviction was/is that this tightening will only serve to intensify the strength of the continued downturn in the EuroZone, which could turn into a very hard landing. Support for a rally to new highs in EURUSD was found in the interest rate spread between the EuroZone and the US, which spiked above 200 basis points for the 2-year rates for the first time in many years. But with Bernanke and Paulson's tough words yesterday, that differential has reversed violently in favor of the USD by over 40 basis points since Friday's close. Bernanke said he felt that the risks to the economy were easing and that he will "strongly resist" any jump in price expectations. So where do we go from here? 1.5800 and 1.5400 are the approximate swing areas that may give us a hint. We must also consider the G-8 conference this weekend when thinking of the USD trajectory. What will the US Treasury have to say today about the USD? Will we see a stronger statement emerging from the G-8 on the plight of the USD?

The odd thing in our view with all of the tough talk on inflation from the Fed and the ECB is that we seem to have an ugly Round 2 of the credit crisis brewing in the background - have the Fed and ECB lost the plot? Going long risk aversion trades may be the best bet soon. These trades have not performed well in recent days with the inflation focus, but the market may begin to smell the coffee as the skeleton rattling in banks and other financial institutions' closets reaches a crescendo....a short EURCHF trade is one basic way to play this, but a refocus on risk would also eventually send the JPY pairs tumbling.

Yesterday, GBP got a heady boost from very high inflation data. But as with the EuroZone, the idea of GBP getting a boost on high rates doesn't have a very sustainable future, as tighter credit eventually serves as a "recession enhancer" more than it does as a supporter of value.

Chart: USDCAD
Watch USDCAD today with the Bank of Canada rate decision, in which the bank is expected to cut rates 25 bps to bring the rate to 2.75%. US and Canadian 2-year rates are rapidly approaching parity and were it not for the oil rally, USDCAD would be trading far higher. The key resistance levels are the trendline resistance just around the overnight high at 1.0260, and then the huge range resistance and old low coming in at 1.0340/80. First big support comes in at 1.0095.