IFO Watch: Weak German Print Could Spark Rate-Cut Talk

The EUR/USD broke below 1.30 Tuesday but the sell-off has been unconvincing. While the currency pair traded down to a low of 1.2973 intraday on the back of weaker German PMI numbers, it ended the North American trading session right around 1.30. Traders reacted very negatively to the PMI report, taking the EUR/USD from 1.3060 to 1.2975 in approximately 30 minutes but it failed to extend its losses. This may have to do with the steady euro zone PMI composite index and the rise in U.S. and European stocks but the numbers were terrible and made worse by the fact that Germany, the region's largest economy is feeling the deepest blow. Considering that German growth supported the region at the end of last year and beginning of this year, the weakness that the country is beginning to feel will have ripple affects across Europe. If Wednesday's German IFO report also surprises to the downside and shows deterioration in business confidence, the European Central Bank could lay the foundation for a rate cut when they meet next week. Recent comments from policymakers show an increased inclination to ease that will be hardened by a drop in business confidence and recent economic reports from China and the U.S. If the outlook for Chinese or U.S. growth was promising, ECB officials could lean on the possibility of stronger export demand but unfortunately that is not the case and the slowdown abroad poses a greater risk to export demand.

Euro-zone PMI numbers are important leading indicators for other economic reports and so the decline in German economic activity foreshadows further weakness ahead. If the German IFO report also shows a drop in business confidence, the EUR/USD could fall to 1.29 as traders start to price in the potential for a rate cut next week. We believe the ECB may postpone easing to June but this view really depends on how much business confidence declines if at all. Remember, stocks have been doing well and industrial production and factory orders increased.

It is also worth mentioning that the biggest mover was the Swiss Franc, which dropped more than 1% against the U.S. dollar and Japanese Yen and approximately 0.7% against the euro. Switzerland reported a smaller drop in its trade surplus and a nice 5.1% rebound in exports. The move was not indicative of intervention by the central bank as it happened gradually during the North American trading session and the only potential explanation for the move are expectations that the SNB will continue to defend the 1.20 level in EUR/CHF or some unreported merger and acquisition flow.

USD: Simultaneous Slowdown In U.S. And China Could Ease Equity Rally
Despite weaker economic data, the U.S. dollar was the best performing currency Tuesday as concerns about Chinese and European growth stir fresh worries about the global recovery. U.S. new home sales increased 1.5% in the month of March but any optimism stemming from the stronger increase last month was offset by a big downward revision the prior month. New home sales dropped 7.6% in February compared to an initial estimate for only a 4.6% decline. Manufacturing conditions in the Richmond region also contracted in the month of April but yet weaker economic data did not stop USD/JPY from trading like it wants to take another stab at 100. Still investors have plenty of reasons to be worried about global growth as weaker Chinese GDP numbers and now a contraction in German service and manufacturing activity followed the slowdown in U.S. non-farm payrolls at the beginning of the month. China's HSBC Flash PMI index dropped from 51.6 to 50.5 in April. The weakness was broad-based with export orders dipping into contractionary territory. While the HSBC index hasn't always forecasted the official release accurately, it is nonetheless a reliable measure of the country's overall economic activity. A simultaneous slowdown in the U.S., China and Europe could take some steam out of the equity market rally. U.S. durable goods orders are scheduled for release Wednesday and a pullback is expected after the strong rise in February.

GBP: Manufacturing Activity Measures Drops To 2.5-Yr. Low
The British pound traded lower against the U.S. dollar and higher against the euro after better than expected fiscal data. The country's budget deficit narrowed in the month of March to 15.1 billion pounds from 16.7 billion a year earlier. Considering that economists were looking for a deficit of 15.5 billion pounds, the data was generally in line with expectations. Tax income receipts continued to fall, reflecting the toll that weaker U.K. growth is having on fiscal finances. The data painted a healthier outlook for the U.K. economy than fundamentals suggested due to one off factors such as the Royal Mail Pension Fund transfers (RMPF) and the BoE's Asset Purchase Transfer (APF). According to the Confederation of British Industry manufacturing orders plunged in the month of April. The industrial trends survey found total orders dropping to its lowest level in 2.5 years. This is bad news for the U.K. manufacturing sector because the CBI has a strong correlation with PMI. Nonetheless the pullback could be temporary as business optimism increased.

NZD: Lifted By Optimism From The RBNZ
The New Zealand dollar traded higher after the Reserve Bank's monetary policy announcement. The RBNZ left interest rates unchanged at 2.5% and instead of focusing on the negative implications of the drought, they said growth has picked up with consumer spending increasing and the Canterbury rebuilding efforts gaining momentum. They also indicated that house price inflation is high in some regions and that the medium term outlook for their trading partner's GDP growth is strong. The central bank is worried about the strong currency and the headwinds it creates for the economy but that was clearly not enough for them to tone down their optimism. Weaker Chinese PMI numbers also drove the Australian dollar lower against the greenback. Leading indicators increased in February but softer Chinese manufacturing activity is a red flag for Australia's economy. Australia's quarterly consumer price report is due for release this evening. CPI is important because weaker inflationary pressure gives the Reserve Bank room to ease. However, CPI is expected have increased as commodity prices moved higher in the first three months of the year. Traders may discount any bump in CPI as commodity prices plunged in April. To be more specific, oil prices started the year at $90 a barrel and ended the first quarter at $97 a barrel but now has fallen to $89.50 a barrel. Meanwhile the Canadian dollar recovered earlier losses to end the day virtually unchanged against the U.S. dollar on the back of stronger than expected retail sales numbers. Consumer spending increased 0.8% in the month of February, more than double market expectations. While rising gas prices boosted spending, Canadian consumers also spent more on electronics, shoes, appliances and general merchandise. Sales excluding autos rose 0.7%. Bank of Canada Governor Carney was quick to say that that the weaker currency is providing a bit of stimulus to the economy. The better than expected data and optimistic comments from the BoC could set the CAD apart from other currencies.

JPY: Keep An Eye On These Potential Triggers
It was a mixed day for the Japanese Yen, which weakened against the U.S. and Canadian dollars but strengthened against all other currencies. The focus remains on USD/JPY and when the currency pair will finally make a concerted effort to break 100. Over the past three weeks we have seen how important this level is and at this point it appears that a catalyst is needed for it to broken. There's nothing on the calendar that could trigger such a significant move in the next 24 hours but on Thursday morning in Japan, the Ministry of Finance releases its weekly report on Japanese purchases of foreign bonds - which could be the first potential catalyst for a break higher. We have been waiting for evidence of Japanese investors diversifying into foreign bonds and if we finally get it, the doors could open for a stronger move higher as investors look for this trend to gain momentum. Over the weekend, the Wall Street Journal noted that Japan's insurance sector, which holds more than 3 Trillion dollars in assets may begin to shift part of its portfolios into foreign bonds as they seek higher returns than the ultra low yielding Japanese Government bonds. Last night, the Nikkei, Japan's leading newspaper, carried a similar sotry reporting that Japan lifers plan to increase foreign investments this fiscal year. If the MoF's data fails to drive USD/JPY above 100, then it will be up to Friday's BoJ meeting, semi-annual outlook report and Japanese CPI data to trigger the break.

Kathy Lien, Managing Director of FX Strategy for BK Asset Management.