Eurozone Recession Rages as ECB Ponders Next Move

Following Tuesday’s dismal German PMI data and today’s IFO report, the European Central Bank (ECB) may now have just reason to cut interest rates as soon as next week, weighing heavily on the euro in the process.

The EURUSD broke below 1.30 on Tuesday, but the selloff has been unconvincing. While the currency pair traded down to an intraday low of 1.2973 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 EURUSD from 1.3060 to 1.2975 in approximately 30 minutes, but it since failed to extend its losses. This may have to do with the steady Eurozone PMI composite index and the rise in US and European stocks, but the German PMI numbers were terrible and made worse by the fact that Germany—the region's largest economy—is now feeling the negative impact of austerity measures.

Considering that German growth supported the region at the end of last year and beginning of this year, the weakness that the country is now feeling will have ripple effects across Europe. If Wednesday's German IFO report also surprises to the downside and shows deterioration in business confidence, the European Central Bank (ECB) could lay the foundation for a rate cut when officials meet next week.

See also: New Data Disaster Fuels ECB Rate-Cut Rumors

Recent comments from ECB 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 US. If the outlook for Chinese or US 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 also poses a greater risk to export demand.

Eurozone PMI numbers are important leading indicators for other economic reports, so the decline in German economic activity foreshadows further weakness ahead. If the German IFO report also shows a drop in business confidence, the EURUSD 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 until June, but this view really depends on how much business confidence declines… if it does so at all. Remember, stocks have been doing well and industrial production and factory orders have increased.

It is also worth mentioning that Tuesday’s biggest mover was the Swiss franc (CHF), which dropped more than 1% against both the US dollar (USD) and Japanese yen (JPY), and approximately 0.7% against the euro (EUR).

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. The only potential explanations for the move are 1) expectations that the Swiss National Bank (SNB) will continue to defend the 1.20 level in EURCHF; or 2) some unreported merger and acquisition flow.

A Perfect Storm That Could Stall the Equity Rally

Despite weaker economic data, the US dollar was the best-performing currency as concerns about Chinese and European growth stir fresh worries about the global recovery. US 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 a 4.6% decline.

Manufacturing conditions in the Richmond region also contracted in the month of April, but weaker economic data did not stop USDJPY 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 US 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 forecast the official release accurately, it is nonetheless a reliable measure of the country's overall economic activity.

A simultaneous slowdown in the US, China, and Europe could take some steam out of the equity market rally. US durable goods orders are scheduled for release on Wednesday, and a pullback is expected after the strong rise in February.

UK Manufacturing Activity Hits Multi-Year Low

The British pound (GBP) traded lower against the US dollar and higher against the euro after better-than-expected fiscal data. The country's budget deficit narrowed in the month of March to GBP 15.1 billion from GBP 16.7 billion a year earlier. Considering that economists were looking for a deficit of GBP 15.5 billion, the data was generally in line with expectations.

Tax income receipts continued to fall, reflecting the toll that weaker UK growth is having on fiscal finances. The overall data, however, painted a healthier outlook for the UK economy than fundamentals initially suggested due to one-off factors such as the Royal Mail Pension Fund transfers and the Bank of England’s asset-purchase transfer.

According to the Confederation of British Industry (CBI), manufacturing orders plunged in the month of April. The industrial trends survey found total orders dropping to the lowest level in two-and-a-half years. This is bad news for the UK manufacturing sector because the CBI has a strong correlation with PMI. Nonetheless, the pullback could be temporary, as business optimism increased.

Central Bank Comments Help Boost Commodity Dollars

The New Zealand dollar (NZD) traded higher after the Reserve Bank of New Zealand (RBNZ) monetary policy announcement. The RBNZ left interest rates unchanged at 2.5%, and instead of focusing on the negative implications of the drought, the Bank said that growth has picked up with consumer spending increasing and the Canterbury rebuilding efforts gaining momentum.

The RBNZ also indicated that house price inflation is high in some regions and that the medium-term outlook for New Zealand 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 reason to tone down the optimism.

Weaker Chinese PMI numbers also drove the Australian dollar (AUD) 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 was due for release Tuesday evening. CPI is important because weaker inflationary pressure gives the Reserve Bank of Australia (RBA) 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, however, 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 have since fallen to $89.50 a barrel.

Meanwhile, the Canadian dollar (CAD) recovered earlier losses to end Tuesday virtually unchanged against the US dollar on the back of stronger-than-expected retail sales numbers. Consumer spending increased 0.8% in the month of February, which was 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 also rose 0.7%.

Bank of Canada (BoC) Governor Mark 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 help set the CAD apart from other currencies.

Triggers That Can Help USD/JPY Break 100

It was a mixed day for the Japanese yen, which weakened against the US and Canadian dollars but strengthened against all other currencies. The focus remains on USDJPY and when the currency pair will finally make a concerted effort to break 100.

Over the past three weeks, we have seen how important the 100 level is, and at this point, it appears that a catalyst is needed for it to broken. There's nothing on the economic calendar that could trigger such a significant move in the next 24 hours, but on Thursday morning in Japan, the Ministry of Finance (MoF) releases its weekly report on Japanese purchases of foreign bonds, which could be the first potential catalyst for a break higher.

See related: USD/JPY: 3 Must-Have Catalysts for a Break of 100

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.

If the MoF data fails to drive USDJPY above 100, then it will be up to Friday's Bank of Japan (BoJ) meeting, semi-annual outlook report, and Japanese CPI data to trigger the break.

By Kathy Lien of BK Asset Management

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