Dollar weaker as German business confidence defies weak PMI prints

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The US dollar is broadly weaker on the day but with most major currencies still trading within a relatively narrow range. The euro rose to an intraday high of 1.3343 following strong German IFO data, a level not seen since December, before falling back below the 1.33 handle after the downbeat revisions of the EU growth forecasts and rumors of a Portuguese downgrade. The yen is also off its intraday high of 80.40 against the dollar and sterling is holding just above the 1.57 level after better-than-expected CBI factory orders data. Asian equities closed mixed and S&P futures are pointing to a flat open. European stocks are mostly lower led by declines in the Spanish and Italian bourses, which are down over 1% led with losses concentrated in the in the utilities sector. Yields on periphery 10-year debt are little changed.

The German Ifo business index defied yesterdays weak PMI prints, jumping to 109.6 from 108.3. The reading was much stronger than the consensus and the highest reading since July 2011. Expectations increased as well, to 102.3 after 100.9 in January while the assessment of the current situation picked up to 117.5 from 116.3, the first improvement since June. With the business index marking its fourth straight monthly increase, the odds are in favor of Germany narrowly avoiding a recession. The improvement in the business climate was visible across all sectors, with construction seeing the largest increase, up to 3.3 from -3.6%. On balance, the solid survey results indicate that for the most part domestic demand should be supportive of growth. Together, with the positive trend in the labor market and a healthy outlook for wage growth, a positive wealth effect and very low interest should continue to support business and household investment. Overall, the Ifo index suggests that German economic activity is improving but this outlook also shows the economic divergence between the core and the periphery.

We continue to see the euro being pulled by two opposing forces. On the one hand, next week’s second LTRO should be supportive of risk appetite since the first operation resulted in a significant reduction in the euro risk premium, namely a drop in the euro basis swaps and bond yields. In fact, from December 14 to today 1-year euro-dollar basis swaps have improved considerably from -106bps to -61bps, while a GDP-weighted composite of the 10-year bond yields declining by nearly 66bps. On the other hand, the outlook for the euro is complicated by Greece which is likely to vote on a PSI bill that includes the CACs provision to retroactively write-down some of its debt on bond holders that are not participating in the bond swap. That said, we expect uncertainty stemming from implementation of the PSI and Greek elections to temper any gains coming from the LTRO. We believe the euro is likely to remain confined to its recent trading range with a convincing break of 1.334 needed to test 1.355. Support near 1.32.

In Australia, politics is taking center stage as Prime Minister Julia Gillard called a snap party election for February 27 following Kevin Rudd’s resignation as foreign minister. She said that she will return to a minor role within parliament and will not seek the leadership again if she fails to win support from her party. In terms of the market impact, we believe that the main policy issues facing AUD is the outcome of the mining tax. On its own this policy response is likely to be negative for the AUD as it would reduce mining investment. Together, with the potential for policy easing from the RBA this policy mix would be negative for the currency, though our baseline scenario is that the RBA remains on hold in March. Nonetheless, since Rudd originally proposed the mining tax and can be viewed in favor of this policy shift, a Rudd victory should be viewed a negative for the AUD. However, we continue to see external factors as the key driver for the AUD and think that domestic policy will play a limited role for the time being. That said, a Rudd victory, together with uncertainty over Greece could see the AUD consolidate further following the 0.6% over the past week. Near-term support at 1.06, while resistance is at 1.085.

With carnival over in Brazil, markets will be focusing on today’s external data and on the prospect for USD/BRL to break below the 1.70 level for the first time since October. We doubt today will be the day of the decisive break, barring a very strong pickup in global risk appetite. The USD/BRL 1.70 level combines the strong technical resistance of an important psychological level with the 200-day MA. It is also a point where the government and the central bank are thought to be especially sensitive. At 7:30am EST we get the January current account numbers. Markets are looking for a record m/m current account deficit of $7bn vs. $6bn in December, and a FDI to drop to $4.5bn from a very elevated $6.6bn in the previous month. Baring any major surprise, the numbers will confirm the continued weakening of Brazil’s external finances even though FDI coverage remains health. The numbers should provide further ammunition for the government to continue its heavy handed policy towards BRL and to lean against a break of the USD/BRL 1.70 level.

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