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- British Pound Falls as Q1 UK GDP Contracts the Most Since 1979
- Euro Gains as German IFO Survey Reflects Improved Sentiment

US Dollar, Japanese Yen Under Pressure as G7 Issues Fairly Optimistic Outlook
The US dollar ended Friday down sharply, while the Japanese yen gained only against the British pound, US dollar, and euro. In economic news, durable goods orders fell a smaller-than-expected 0.8 percent in March, and excluding transportation orders fell 0.6 percent. A breakdown of the report shows that broad based declines, though non-defense capital goods orders excluding aircraft - a gauge of business sentiment - rose for the second straight month.

Meanwhile, a white paper describing the process and methodologies of the US government's stress-tests of the 19 biggest financial institutions showed that while most of the firms had capital well in excess of regulatory standards, reserves at some banks have been substantially reduced by the recession and market turbulence. As a result, it is clear that the US government will step in to provide additional funding in order to provide a greater buffer, but the fact that most of the banks are in decent shape appeared to be optimistic news to the markets, as risky assets like stocks and FX carry trades ended the day higher. Looking to the economic scenarios that the test relied on, there are signs that the more adverse scenarios may ultimately be more reliable. Indeed, the average baseline for the unemployment rate was listed at 8.4 percent, but according to the latest data, the unemployment rate had already hit 8.5 percent in March and is only anticipated to rise further. Thus, the alternative scenario of an unemployment rate at 8.9 percent in 2009 and 10.3 percent in 2010 may be more accurate.

Finally, the G-7 draft said that a weak economic recovery would start later this year as signs of stabilization have emerged. Ultimately, a reiteration of these statements over the weekend has the potential to boost risk appetite on Sunday, which could contribute to US dollar and Japanese yen weakness.

British Pound Falls as Q1 UK GDP Contracts the Most Since 1979
The British pound ended Friday as the weakest of the majors as Q1 GDP for the UK fell for the third straight quarter, this time contracting at a rate of -1.9 percent. This was the worst drop since 1979, and the plunge dragged the year-over-year rate down to match the Q4 1980 low of -4.1 percent. The UK has been hit particularly hard by the credit crunch, especially since the country became one of the biggest financial centers in the world. This has translated into a full-on collapse of the housing market, climbing job losses, and weak consumption. Furthermore, with growth slowing around the world, demand for British exports has declined as well, putting a large burden on producers. In fact, of all the components, manufacturing showed the sharpest contraction of all at -6.2 percent.

At this juncture, the Bank of England has likely cut the Bank Rate as low as they're willing to go, but an acceleration of the UK economic contraction would add to risks that the central bank will expand their quantitative easing efforts. This leaves downside risks open for the British pound, and when looking to GBP/USD, the pair's consolidation within a rising wedge (on the hourly charts) suggests that price could fall back toward at least 1.4450 in the near-term.

Euro Gains as German IFO Survey Reflects Improved Sentiment
Over the past week, the euro was one of the winners against the other majors, but ultimately, the currency ended the day down against everything but the ultra-weak British pound and US dollar. European data was surprisingly strong, as the German IFO survey of business confidence rebounded from a 26-year low in April to 83.7. Likewise, the IFO survey on current conditions rose to 83.6 from 82.7, while the survey on economic expectations jumped to 83.9 from 81.6, indicating that interest-rate cuts, gains in the stock markets, and government stimulus packages have helped to improve sentiment. Interestingly enough, Credit Suisse overnight index swaps are actually pricing in a slight chance of a 25 basis point increase in May, but there are signs that we could see the opposite.

First, various ECB officials, including ECB President Jean-Claude Trichet, have indicated that they have the option of doing so, though they've essentially written off cutting rates below 1 percent. Also, deflation could become a threat for the region. As we mentioned yesterday, the annual rate of CPI growth Spain and Portugal fell negative during March, and in Ireland, the annual rate has held negative for the past three months. However, with inflation growth still holding positive in larger member countries like Germany and France, headline CPI numbers for the Euro-zone as a whole have held positive as well. The ECB has said in the past that they expect CPI to fall negative later in the year, and once those figures come to fruition, deflation concerns may become more widespread.

Related Article: Euro/US Dollar Loses Correlation to S&P 500 - Time for Turn Lower

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Written by: Terri Belkas, Currency Strategist for DailyFX.com
E-mail: tbelkas@dailyfx.com