Weekly Forex Currency Review 02-03-2007

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Overall strategy

Levels of risk aversion will remain an extremely important market factor with the net risks suggesting further recoveries for the Swiss franc and yen in volatile trading. Defensive flows to the US will provide dollar protection, but the US currency will struggle to secure substantial buying support without a series of stronger economic data.     

Key events for the forthcoming week

Dollar

The ISM recovery will offer some reassurance over the manufacturing sector, but there will still be doubts over overall growth trends with persistent unease over the housing sector and fears over rising defaults. The dollar will need a series of more robust reports to eliminate speculation over a cut in interest rates later this year. A sustained increase in risk aversion would tend to undermine the dollar in the medium term, but there is the potential for short-term capital repatriation back to the US which will support the dollar. 

The dollar weakened to lows near 1.3260 against the Euro as confidence over the economy remained weak, but the US currency strengthened back to 1.3170 as the Euro was unable to sustain gains above the 1.3250 level.

A reduction in speculative Euro positions and capital repatriation flows to the US on higher risk aversion offered some dollar protection against the Euro.

The US data was mixed over the week and growth concerns increased over the middle of the week as fourth-quarter GDP growth was revised down to 2.2% from 3.5% originally. The Chicago PMI index remained below the 50.0 level for February while there was a sharp fall in durable goods orders and a drop in new home sales.

The February national ISM index recovered back above the 50.0 level with a reading of 52.3 from 49.3 in January. The report eased immediate concerns over the industrial sector, especially as the price and orders components also improved over the month.

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Markets will remain very confident over an ECB interest rate increase next week and the Euro-zone economic data has remained generally encouraging. Inflation indicators have remained benign which will increase calls for the ECB to delay any further increase in interest rates and this will tend to deter Euro buying. The currency should remain firm, but will struggle to extend gains beyond 1.3250 against the dollar, especially given the number of long speculative positions.

The Euro weakened against low-yield currencies over the week, but held relatively steady in trade-weighted terms as overall sentiment remained strong.

The Euro-zone growth data remained generally firm over the week with the PMI manufacturing index little changed at 55.6 for February. There was a further sharp decline in German unemployment for the month, but January retail sales fell.

ECB officials continued to take a tough stance on policy and clearly suggested that the bank would look for an interest rate increase at the March meeting.

The inflation data remained subdued with the provisional February Euro-zone rate at 1.8%, still below the 2.0% central bank ceiling. The subdued inflation rate created some industrial and political pressure on the ECB to suspend interest rate increases.

Yen

There will be slightly greater confidence over the economy and speculation over a further interest rate increase. Carry trades will still tend to be the dominant short-term influence with the potential for continuing position adjustment. With further capital repatriation ahead of the fiscal year, the yen should retain a firmer stance in the short-term and there will be a risk of gains to at least 115.0 against the dollar on disorderly position unwinding.
                    
The US dollar was unable to hold above 121.0 against the yen and the yen strengthened sharply to highs around 117.0 as volatility levels increased sharply.

Risk aversion rose sharply, triggered in part by a drop in Asian stock markets, and this mood shift put strong upward pressure on the yen as sell trades were covered.

The economic data was of secondary importance with a drop in industrial production. Core consumer prices were unchanged over the year, but household spending rose.

Bank of Japan and government officials took a generally more optimistic stance on the economy during the week which helped narrow the US yield premium over the yen and this contributed to the Japanese currency gains.

The latest capital account data recorded a further inflow of funds into Japan, maintaining the trend seen over the past few weeks.

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The more aggressive interest rate expectations are still liable to be scaled back, but domestic trends will still offer near-term support. There will be the risk of a reduction in shorter-term capital inflows, especially if stock markets continue to fall, as merger inflows would tend to be weaker. Sterling may struggle to find direction in the very short-term with resistance close to 0.67 against the Euro, but an interest rate increase next week would strengthen the currency.

Sterling weakened to lows of 0.6755 against the Euro on a reduction in buy trades funded through the yen, but recovered to 0.6725. The UK currency was held in relatively narrow ranges against the dollar with selling interest above 1.9650.

Although there was little in the way of major economic data, the underlying tone was firm. The CIPS index for the manufacturing sector rose to 55.4 in February from 52.8 the previous month while the CBI distributive trades survey reported a healthy February sales increase. There was also evidence of rising prices in the survey.

The housing data recorded some slowdown in mortgage advances, but the Nationwide Bank reported a further increase in house prices for February.

Swiss franc

The National Bank is likely to increase interest rates in March and underlying demand for defensive currencies is likely to remain higher in the short-term as risk aversion levels remain elevated. There will still be some interest in selling the franc on yield grounds but markets, overall, are likely to be much more cautious. Persistent financial-market stresses could trigger further sharp franc gains. 
 
The Swiss currency strengthened sharply against the Euro and dollar over the week with highs near 1.6060 and 1.2140 respectively. Carry trades and market positioning remained a very important factor with defensive currencies such as the franc securing a notable recovery from recent losses.

The sharp drop in global stock markets, coupled with increased risk aversion and fears over global growth, triggered a reduction in speculative short franc positions.

The Swiss KOF leading indicator strengthened to 1.79 in February from an upwardly-revised 1.74 the previous month and the domestic data as a whole remained strong. 

Swiss National Bank member Jordan stated that the bank would continue to normalise monetary policy which clearly suggested that interest rates would be increased again at the March central bank meeting.

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The Australian dollar strengthened to 0.7940 against the US currency, but was unable to hold the gains and retreated to lows below 0.7850 late in the week.

There was a 0.9% increase in retail sales for January and the current account deficit rose. International trends were the dominant market influence over the week.

The Australian dollar was unsettled by a drop in gold prices during the week while the drop in stock markets increased concerns over global growth trends. There was some reduction in investment flows from Japan as domestic investors turned more cautious.

Reduced confidence in high-yield currencies will tend to restrict Australian dollar buying interest in the short-term with the currency vulnerable to some further selling.
 
Canadian dollar

The Canadian dollar strengthened to highs around 1.1580 against the US currency, but was unable to hold the gains and weakened to lows around 1.1740 before stabilising.

The currency was buffeted by movements in commodity prices over the week as global market turbulence created volatile moves across all asset classes.

The current account surplus narrowed in the fourth quarter of 2006 as the investment account deteriorated, although the underlying trade position remained firm.

The Canadian currency should be able to avoid heavy losses in the short-term even if gains are hampered by doubts over global growth trends.

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The rupee was weaker over the week, but with sharply conflicting market pressures evident as global market volatility increased. The rupee weakened to six-week lows around 44.37 against the dollar before a slight recovery.

The rupee was undermined by higher global risk aversion with institutions withdrawing funds from the local market. Although the volumes appeared moderate, there were fears over further outflows as global tensions persisted over the week.

Regional trends were supportive with strong yen gains helping to underpin the Indian currency. Initially, there was central bank intervention to stem rupee gains and there was also suspected intervention to curb losses at the height of market volatility.

Given higher risk aversion, the rupee will find it difficult to regain buying support in the very short-term even if losses are contained near current levels.

Hong Kong dollar

The Hong Kong dollar briefly strengthened through the 7.81 level against the dollar, but failed to hold the gains and weakened back to 7.8130.

The budget announced tax cuts but the fiscal policy announcements failed to have a major impact on the market with markets focussing on the stock market trends.

Persistent stock market fears undermined the local currency with the Hang Seng index falling for five consecutive sessions before a limited recovery on Friday.

A slight recovery in US yields late in the week stifled the Hong Kong dollar, but overall arbitrage activity was at a lower level.

The Hong Kong dollar is unlikely to strengthen to any great extent, but should be able to find support close to 7.8150.