After a spike higher going into the weekend and hitting a 2011 high of $1.4268, the euro was largely range bound versus the USD yesterday before coming under some modest selling pressure in early morning trade on the back of news that Moody’s have downgraded Portugal’s sovereign debt. The dollar, however was held back by dovish comments from the Fed’s president overnight. Following on from comment from the Fed’s Dudley late on Friday, Bernanke sought to downplay fears of inflation, suggesting that monetary policy will remain on hold for some time yet. These comments were echoed by remarks from other Fed officials yesterday, offsetting the impact of somewhat hawkish comments seen last week.

Markets will be looking to this evening’s release of the minutes of the last FOMC meeting for any further policy clues. The Portuguese debt downgrade also put the euro under some pressure versus the yen but downside should be limited by expectations of a eurozone interest rate hike from the ECB later in the week. Meanwhile, sterling found some support versus the euro and dollar yesterday, underpinned by anticipation of positive M&A flows and a better than expected report from the UK’s construction sector. Upside, however, is seen as limited for now.

In other news overnight, the Reserve Bank of Australia announced that it was leaving interest rates on hold at 4.75% for the fifth month running. The AUD stayed close to 29 year highs following the announcement, which was in line with expectations. There was little indication of a near term return to a tightening cycle with the central bank saying that a strong currency, moderate wage growth and intense retail competition should all help to keep inflationary pressure under control.

European Central Bank in the spotlight

The European Central Bank is widely forecast to raise interest rates this week, with priced-in expectations showing the markets are certain of at least a 25bps increase and see a 46 percent probability of a 50bps hike. With that in mind, it is interesting to see that EURUSD is closer correlated with the 5-year Spanish CDS – a measure of the perceived likelihood of a sovereign default beyond the scope of the EFSF bailout fund – than any established gauge of the monetary policy outlook. That suggests the rate hike has been amply priced in and is unlikely to prove market-moving absent an overtly hawkish shift in rhetoric from ECB President Jean-Claude Trichet, shifting the focus to Portuguese and Spanish bond auctions on Wednesday and Thursday, respectively.