Weekly Forex Currency Review 01-02-2008

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Overall strategy: The dollar will remain very vulnerable on yield grounds following the aggressive Fed stance on interest rates during January. There will be scope for investment inflows, especially as markets will look to anticipated a US recovery which will provide dollar protection and volatility levels are liable to remain high. Carry trades will find it difficult to secure a sustained recovery while global growth fears persist.                     

Key events for the forthcoming week

Dollar:

Yield support for the dollar has fallen substantially over the past two weeks which will tend to undermine the US currency, especially as there is no evidence at this stage that the Fed thinks interest rates have reached a floor. There will also be further unease over the threat of recessionary conditions in the US economy. These negative influences will be offset by the potential for investment inflows on hopes that the Fed action will be able to stimulate a recovery from late in 2008. Increased unease over the global economy will also provide some degree of dollar protection.    
      
Dollar moves remained erratic over the week, but there was a net weakening trend. The US currency hit fresh record lows against the Swiss currency and was unable to secure any significant recovery against the yen. The trade-weighted index fell to the lowest level of 2008 during the week.

At the regular FOMC meeting, the Federal Reserve cut interest rates by a further 0.50% with the Fed funds cut to 3.00%. The central bank also announced a 0.50% reduction in the discount rate.

The Fed stated that there were downside risks to the economy while credit conditions had tightened and that the housing correction had deepened. The Fed also cited evidence of a weaker labour market for the further reduction in rates. There was a 9-1 vote for the decision with Fisher calling for no change.

The US economic data had a mixed tone over the week. There was a robust report for durable goods orders with a 5.2% December increase. The ADP employment report also recorded a stronger than expected 130,000 increase in jobs for January.

In contrast, jobless claims rose to 375,000 in the latest week from 306,000 previously while consumer confidence remained weak. New home sales weakened further to 604,000 in December which was the lowest selling rate for over 15 years while indicators of house prices also weakened over the month.

Inflation indicators were of secondary importance with a second successive 0.2% increase in the core PCE reading which gave a 2.2% annual increase.

There were reports that Qatar would revalue its currency against the dollar which unsettled the dollar to some extent.

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There will be persistent fears over the growth trends within the Euro-zone economy. A key feature is also likely to be greater fears over serious divergence within the individual economies. These pressures would also create significant tensions within the ECB with growing calls for lower interest rates. The majority of the central bank council will look to retain a restrictive stance in the short-term. A tough stance will support the Euro if growth conditions appear to be holding firm. The currency will, however, struggle to make much headway and evidence of serious growth deterioration would weaken it sharply.          

The Euro secured net gains over the week, but it was struggling to find firm buying support even though it came within 50 points of record highs against the dollar. The currency secured gains when global risk aversion eased.

There was a further decline in Euro-zone business confidence for December while consumer confidence also weakened over the month.

There was a further 0.1% decline in German retail sales to record a 6.9% decline in the year. French consumer confidence also weakened sharply over the month.

The provisional Euro-zone inflation estimate rose to 3.2% in January from 3.1% the previous month compared with the 2.0% ECB target.

Yen:  

There will be further concerns over Japanese economic trends and there will also be some speculation that the Bank of Japan will cut interest rates. Nevertheless, there is a very strong probability that the bank will keep rates on hold over the next few months. There will be capital flows from Japan, but seasonal considerations will be more favourable for the yen over the next two months given the potential for capital repatriation. There is scope for net yen gains, although consolidation pressures will stifle the potential for a near-term advance.    
                    
The Japanese currency weakened slightly against high-yield currencies over the week as stock markets attempted to rally, although the currency was able to resist heavy selling pressure as caution prevailed. The dollar consolidated around the 106.50 area against the Japanese currency.

The yen movements were still correlated strongly with degrees of risk aversion and movements in global stock markets. The Japanese currency dipped significantly when global markets rallied.

The Bank of Japan continued to express reservations over the economic outlook while there were no major comments from Finance Ministry officials.

Industrial production rose 1.4% in December after a significant decline the previous month with the annual increase held to 0.7%. The unemployment rate held at 3.8% for December while the jobs/applicants ration remained below the 1.00 level which suggested the labour-market was still fragile

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Confidence in the UK economy will remain weak in the short-term with further expectations of a sharp slowdown in growth and fears that a housing sector deterioration could threaten a recession. There is a very strong probability that the Bank of England will cut interest rates in February and pressure for further rate cuts will increase. A substantial deterioration has, however, been priced in and Sterling will gain some support if there is evidence of resilience. The UK currency will still find it difficult to secure more than a limited advance.     
 
Sterling continued to strengthen against the dollar during the week, although momentum slowed with resistance above the 1.99 level. Sterling was confined to a 0.7410-0.7490 range against the Euro.

The Nationwide Bank reported that house prices fell by 0.1% in January, the third successive monthly decline, with a 4.2% annual increase. Mortgage approvals fell to a 12-year-year low for December while consumer credit growth was subdued. There was, however, a firm figure for bank lending.

The CBI retail sales survey weakened to +4 in January from +8 the previous month, but retailers were more optimistic over the Februarys prospects.

Bank of England Governor King was nominated for a second five-year term by the government. MPC member Blanchflower repeated his call for interest rates to be lowered further due to elevated growth risks.
 
Swiss franc:

There are likely to be greater doubts over the Swiss economy following a weaker than expected reading for the KOF index and there will be some pressure for the National Bank to cut interest rates if there is evidence of a sharp slowdown. The overall fundamentals will remain robust, however, and the franc is likely to gain further underlying support on defensive grounds as risk aversion levels remain high. Overall, substantial franc loses still look unlikely at this stage.            
 
The Swiss franc weakened slightly against the Euro during the week, but found support close to the 1.62 level. Dollar weakness pushed the franc to record highs near 1.0750 against the US currency before consolidation around 1.08.

Underlying risk aversion continued to provide Swiss franc support even though fear levels were less pronounced than the previous week

The Swiss KOF index fell to 1.70 in January from a revised 1.84 the previous month which was the lowest reading for close to two years. The PMI index held firm at 61.6 in January from 61.3 the previous month which will ease immediate fears.

The December trade surplus also fell to CHF0.2bn from 1.8bn the previous month as real exports fell 3.4% over the year.

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The Australian dollar was subjected to choppy trading during the week. The net trend was for gains against the US currency with a peak close to the 0.90 level.

The Australian private credit growth was firm at 1.6% for December, while there was a drop in hew home sales, although domestic influences were limited.

The Australian dollar was still supported by yield considerations with the impact of US interest rate cuts compounded by speculation that the Reserve Bank could tighten policy again at the February meeting.

The Australian currency moves were still correlated strongly with degrees of global risk aversion with international growth fears also triggering a mood of caution.

The currency will spike higher if there is an interest rate increase. Despite US dollar vulnerability, increased fears over the global economy will still make it difficult for the Australian currency to make much headway in the short-term.

Canadian dollar:

The Canadian dollar strengthened to highs beyond 0.99 against the US currency during the week, but failed to sustain the advance and dipped sharply back to beyond parity as growth fears resurfaced.

Canadian GDP growth was held to 0.1% for December as there was a decline in manufacturing and energy production for the month.

Canadian dollar moves were again influenced strongly by levels of risk aversion and movements in commodity prices over the week.

The currency was unsettled by fears over the North American economic outlook and Bank of Canada hints that interest rates would be cut again.

The growth doubts are liable to prevent significant Canadian dollar gains and any increase in global growth fears would tend to push the currency weaker.

Indian rupee:

The Indian rupee was confined to relatively narrow ranges during the week despite continuing volatility in global markets. The currency settled around 39.37 against the dollar with caution over intervention restraining current gains.

The rupee was undermined to some extent by the refund of payments following the Reliance Power IPO which had been heavily over-subscribed. There were intermittent capital outflows from the domestic stock market, although sentiment remained firm

These negative factors were offset by an improvement in yield support following another interest rate cut by the Federal Reserve as the Indian central bank held interest rates steady.

Fears over the global economy and a more cautious stance by global investors will tend to weaken the rupee in February, although heavy losses should be avoided.

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The Hong Kong dollar was generally stronger over the week with a test of levels beyond the 7.80 level against the US currency. The Hong Kong dollar strengthened to highs near 7.7935 on Friday

Official Hong Kong rates matched the Federal Reserve's interest rate cut, but some local banks limited the cut in prime rates to 0.25% which supported the Hong Kong dollar as yield spreads improved.

HKMA chief Yam as generally cautious over the economic prospects while stock market fluctuations were a significant influence

The Hong Kong dollar will struggle to sustain gains much beyond 7.80 against the dollar unless there is speculation over a currency regime change.

Chinese yuan:

The yuan has continued to strengthen over the past week with gains to highs beyond 7.18 against the US dollar before consolidation around 7.1850 on Friday.

For January as a whole, the Chinese currency also posted the largest monthly appreciation against the US dollar since the yuan was floated in 2005.

The evidence suggested that the central bank was encouraging faster yuan gains to help curb inflationary pressure, especially with some evidence that the bank is becoming more wary over sanctioning further interest rate increases amid fears over a slowing economy

The domestic currency was supported by rising yield differentials following the further cut in US interest rates to 3.0%

The yuan is likely to strengthen further over the next few weeks, especially as the central bank appears content to let the currency advance at a faster pace in order to help curb inflationary pressure.

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