The IFO report beat expectations tonight in early European trade, as the reading in the Business Climate conditions rose to 107.7 from 106.5 reversing the… … pattern of two consecutive monthly declines.

The news surprised the market given the sharp drop off in the Belgian Business
indicator last week, the persistently high exchange rate of the euro and
the recent upward creep in oil prices. Yet despite all of these
challenges, European business sentiment continued to hold near record
highs, confirming the euro bull argument that the EZ economic growth may
be decoupling from the evident slowdown in the US.

This week also brings the German employment figures and if, as the
market expects, that release shows improvement as well the case for
another ECB rate hike will be assured. At present the market expects
another 25bp bump in May which would take EZ rates to 4.00% and narrow
the interest rate differential with the greenback to an almost
insignificant 125 basis points.

Although the euro gained only modestly against the dollar in the
aftermath of the release, it enjoyed a much stronger rally against the
Japanese yen as traders put on fresh carry trade positions in the wake
of new evidence that inflation in Japan remains well contained. The
Corporate Services Price Index receded from its recent highs printing at
0.4% vs. 0.6%. The report was just the latest confirmation that subdued
pricing pressures in Japan provide no fundamental reason for the BOJ to
expedite the normalization of its monetary policy which is likely to
keep rates at 50bp throughout Q2 of 2007.

In US today, Consumer Confidence is the sole economic report of
interest to the market. Traders expect a decline to 108.5 from 112.5
the month prior. Given the massive media coverage of the sub-prime
crisis and the steep decline in New Home Sales, a contraction in
consumer sentiment seems to be a reasonable bet. Still, it may be
worthy to watch how this release impacts not only the currency market
but the stock market as well. Up to now the US equity market has been
remarkably resilient in the wake of overwhelming evidence of a US
economic slowdown. Yesterdays recovery in the Dow Jones from a near 100
point plunge in morning trade was just the latest demonstration of
investor bullishness. If Consumer Confidence data does show a large
decline which in turn finally cracks the US equity market, the latest
carry trade positions could come under pressure later in the day. Carry
trades are typically nurtured in an environment of low volatility which
fosters high risk seeking behavior. If US capital assets suddenly
experience a second wave of selling this month, currency traders may run
for safety to the low yielders like the yen and the Swissie and the
carry trade flows could reverse yet again.

By DailyFX