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The European morning session has been fairly volatile for FX markets, with the euro starting off looking fairly well supported at 1.32 and then falling through the floor on the back of some weak Eurozone economic data. The first blow to the single currency came from Germany where it was reported that the unemployment rate jumped by 19,000 in April and the unemployment rate had been revised up to 6.8% from 6.7% for March, which is where it remained last month. This is the largest increase in German unemployment for three years. Although a German labour market official said the decline could be down to the timing of Easter, it was enough to spook the markets.

Not such a two-speed economy?

The other blow to hit the market was the fall in the German manufacturing PMI survey to 46.2, the lowest level since mid-2009, and then confirmation that the entire currency bloc had a weak start to Q2 when the Eurozone manufacturing survey fell to 45.9 last month. This data brings a new dimension to the sovereign debt crisis. For some time the two-speed economy  with Germany and the core countries outperforming the weaker south has helped to keep the euro propped up as it has limited the ECB's ability to cut rates further, as that could stoke inflation risk in countries like Germany. However, if Germany is showing signs of weakness then the ECB would have more room to further stimulate the economy, maybe by cutting the 1% interest rate even further, which would be a welcome relief for countries like Spain. This makes tomorrow's ECB meeting even more important than usual for the markets as we gauge how the ECB views the recent broad-based weakness in the currency bloc.

Of course, these are only tentative signs of weakness in the German economy, and we would point out that the PMI has diverged from other German growth signals including the ZEW and IFO, which have recovered fairly strongly since dipping in November when Spanish and Italian bond yields reached record euro-era highs. Today's Eurozone data is euro negative and we have seen the single currency fall below the key 1.3150 level, which had been a key support zone. Below here opens the way to 1.3100 then to1.3068 - the bottom of the daily Ichimoku cloud chart and the start of a technical downtrend.

The Fed holds the euro's fate in its hands

We tend to think that the euro is headed lower, however it could remain trapped in a range for some time and whether or not it breaks out of the 1.3060-1.330 range will depend on the upcoming economic data from the US. The FOMC meeting last week was ambiguous: although growth and inflation expectations were revised higher and a number of Fed members brought forward their expectations for rate hikes, Federal Reserve chairman Bernanke talked down the upwardly revised forecasts and continued to stress the downside. Thus the market has to use individual economic data releases to piece together the strength of the US economic data and the prospects for further Fed easing or not. Thus, traders and investors alike are all trying to decipher this giant US macro patchwork quilt to determine the likelihood of more central bank action to prop up the markets.

Central banks and the volatility conundrum

But here is the problem: central banks tend to react when volatility spikes higher (hence November's action by the ECB), yet the fact the markets can rely on central banks has kept volatility incredibly low (as measured by the Vix and FX option market), which makes further central bank action less likely. Thus, we could be in for a massive re-pricing of assets as the extent of the risks facing us including the Eurozone debt crisis, political risks in the currency bloc, potential economic depression in countries like Spain and missed fiscal targets all come crashing down to earth in one go. This uneasy balance is unlikely to be maintained - either central bank's have to give up the fight on inflation and continue to pump markets full of money or the markets have to learn to live without the Bernanke put.

Market moves:


The broad-based recovery by the dollar that was kicked off by the strong US ISM report yesterday  also helped propel the Dow Jones to a 4-year high. As mentioned, EURUSD is hitting multi-day lows; the pound looks more supported after managing to claw back some of this morning's losses and is currently testing resistance at 1.62. The yen has weakened and was led lower by USDJPY which easily pushed through 80.00 resistance yesterday; although 80.60 is a thwarting dollar bulls for now.

The risk is that the markets are overreacting to one good data point - the US ISM manufacturing survey - and the dollar could be at risk from a sell -off if today's second data test, the ADP jobs report, is not as strong as the 170k expected. Markets are likely to get jittery in the lead up to the weekend. Tomorrow we have a Spanish debt auction, Friday we have NFP's and on Sunday we have French and Greek elections.  (I also forgot to mention that Greece was upgraded today by S&P to CCC, although this did not cause a market reaction). This could help drive some much-needed volatility into the markets, unless central banks choose otherwise, of course.

European stock markets are neutral to a tad lower this morning, while US stocks are set to open lower, which is perfectly normal after yesterday's surge in the Dow to a 4-year high.

Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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