Euroland: IFO Spurs Doubts on German Strength

Overview:

The German IFO index disappointed in April and fell stronger than expected. The decline was broadly based across sectors and reflected lower expectations as well as assessment of current condi-tions. We have been puzzled about its strength in the past few months, but we may now start to see the slowdown in growth feeding through to IFO. The decline was not a total surprise as markets got a warning from the steep decline in Belgium business confidence yesterday (see Flash Comment - Euroland: Weak Belgium confidence - will IFO follow?).

Details:

The overall index for April fell from 104.8 to 102.4 and both main sub-indices declined with the current conditions index falling from 111.5 to 108.4 and the expectations index falling from 98.4 to 96.8. The decline in expectations is most significant as it is a) the best leading indicator within the IFO index and b) at a lower level at the starting point. On sector distribution we saw lower levels in manufacturing (17.9 to 13.4), retail trade (-0.9 to -10.9) and wholesale trade (7.7 to 1.6) whereas construction confidence was a little higher.

Outlook and assessment:

The German economy is increasingly affected by the massive headwinds hitting the economy at the moment and we have already seen a clear slowdown in consumption growth and some-what slower growth in exports. Investment growth, however, has stayed strong but we think activity in this area will weaken going forward, which is expected to lead to further declines in IFO. For some reason - still puzzling to us - the current conditions index has been at an extremely high level in this cycle. This still keeps the IFO at a high level, but this has not been mirrored in actual growth rates, which have fallen from 4% at the peak to 1.7% in Q4 - close to trend growth. We therefore think it is more useful to look at the change in IFO rather than level.

Financial implications:

The decline in IFO could lead to a sentiment shift regarding the strength of Euroland, as Germany is more or less "the last man standing". The bearish sentiment in bond markets has been sup-ported by upward surprises in IFO and high inflation rates. With IFO declining and inflation peaking soon (fin-gers crossed) this should lead to a sentiment shift in the bond market underpinning lower yields. Markets have more or less taken ECB cuts out of the market on the back of hawkish ECB comments, but we expect cuts to be priced in again - especially because we expect further declines in IFO.

The decline could also be important for the Euro-US country spread, which has gone to extreme levels in this cycle as Fed has cut rates and ECB has stayed on hold based on high inflation and German strength. The decline in IFO will help put a bottom under the spread and if IFO declines further it could be a trigger for reversal.

The relentless drive higher in EUR/USD this year has been based to a large extent on a significant diver-gence of the US and euro area economies. Recently, the exceptionally dovish stance of the Fed has been contrasted by a merciless inflation-focus at the ECB. Our take on the situation has been to look for dollar weakness as long as the financial crisis and economic performance was weighing more heavily on the US. However, we have also tried to forecast a top around the middle of the year (our most recent forecast had 1.6 on the 3m horizon and 1.50 12m out). Behind that call was an expectation that the euro-area could not escape undamaged from the gales that have inflicted so much pain on the US. At times we have found it hard to understand how the ECB could remain so hawkish in the face of higher money market rates, a stronger currency, a global slowdown and the rise in energy prices. The decline in the IFO survey today fol-lows similar declines in the Belgian business indicator and in PMI surveys earlier in the week. If the move is sustained, it could well herald a more negative outlook for the euro area than markets are currently pricing, resulting in a re-pricing of interest rate markets as well as currency markets. However, we cannot make such predictions yet with any great certainty.

Technically, a break below 1.5712, the low from 18 April, would target a move towards the 1.5350 area, the low from 24 March. A break here would send us below 1.50. However, failure to break the former level today could easily send us back to previous highs.

Overall, the hawkish stance of the ECB has been challenged by the weakness of economic indicators this week. More of the same will make it more likely that a fundamental turning point could be approaching. However, the ability of the US economy to disappoint should not be easily dismissed, with next week's non-farm payrolls report and FOMC meeting as key in that regard.

Danske Bank
http://www.danskebank.com/danskeresearch

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