Weekly Forex Currency Review 02-11-2007

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Overall strategy

The dollar will remain vulnerable in the short-term and overall market confidence is liable to remain weak over the remainder of 2007 due to recession fears. There is still scope for limited recoveries and the US currency has now overshot levels against European currencies which would be consistent with longer-term sustainability. Renewed credit-related fears are liable to curb carry trades in the short-term.              

Key events for the forthcoming week

Dollar sentiment will remain weak in the short-term with further fears over a slide towards recession even though the overall growth evidence has been mixed. In this environment, markets are still expecting that the Fed will cut interest rates again despite the formal shift to a neutral policy stance. Increased doubts over the global economy should provide some dollar backing on a relative basis. The US currency should also gain some underlying support from the gradual trade deficit improvement. There is the possibility of a sharp correction from recent heavy losses although rallies will quickly attract fresh selling pressure.   
      
The US currency remained under pressure for most of the week and dipped to record lows around 1.45 against the Euro after Wednesday's Federal Reserve interest rate decision with the trade-weighted index also at fresh 30-year lows.

The Federal Reserve cut interest rates by a further 0.25% to 4.50% at the latest policy meeting. There was 9-1 vote with Hoenig dissenting and calling for unchanged rates.

The Fed also switched to a neutral policy stance as it was more concerned over inflationary pressure while it also stated that market strains had eased. There were still major Fed concerns over the housing sector and credit fears in the markets increased again after investment bank downgrades.

Third-quarter GDP was reported as 3.9% with the housing sector weak. The core inflation deflator held at 1.8% in the year to September while consumer confidence fell to a two-year low according to the latest data.

The ADP employment report recorded a monthly increase of 106,000 from 61,000 the previous month while jobless claims edged lower.

The Chicago PMI report was weak with a slide to below the 50.0 level for October while the national ISM index edged down to 50.9. An important feature was evidence of strong export growth in the GDP report and the ISM report which boosted confidence in a lower trade deficit.

US Treasury Secretary Paulson stated that the US was strongly committed to a strong dollar, but there was no evidence of any intervention to support the currency.

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The evidence continues to point to a significant slowdown in Euro-zone growth. At the same time, short-term inflation pressure has increased under the influence of higher energy prices. This combination of factors will put the ECB in a difficult position as the internal inflation fears will be offset by increased political pressure for a less restrictive policy. Given inflation concerns, the ECB will want to err on the side of restraint in the short-term which will tend to support the Euro unless the growth evidence deteriorates sharply. The growth fears are liable to cap Euro gains as political fears increase.

The Euro retained a generally firm tone over the week, although there was evidence of significant profit taking, especially on Thursday, when a downturn in global stock markets helped undermine the Euro.

The EU Commission's business confidence index weakened to 0.87 in October from 1.08 the previous month while the retail sales data was subdued.

The provisional consumer inflation rate increased sharply to 2.6% in October from 2.1% and the ECB maintained a firm stance on inflation in comments over the week.

There were further rumours of debt write-downs by European central banks which maintained underlying European credit fears.

EU commissioner Almunia stated that currency-market volatility must be addressed, although the exchange rate comments from officials were generally measured.

Yen 

Yield considerations will remain negative for the Japanese currency with the Bank of Japan's reluctance to increase interest rates also a negative factor for the Japanese currency, especially with a downgrading of the growth outlook. The yen will gain firm support when risk aversion rises and there is likely to be a continuing reluctance in extending carry trades. Underlying pressure for Asian currency appreciation will also tend to support the yen to some extent.                      
                    
The yen was undermined by general interest in high-yield currencies for much of the time, although there were significant gains when Wall Street came under selling pressure. The yen found support close to 116.00 against the dollar with a move back towards 114.50 as Wall Street came under selling pressure.

The Bank of Japan again left interest rates unchanged at 0.50% by a 8-1 vote for the second successive month with Mizuno voting for an increase in rates. Bank governor Fukui took a generally cautious stance and the bank downgraded its economic assessment in the latest semi-annual report.

The unemployment rate surprisingly rose to 4.0% from 3.8% the previous month, but there were robust gains for household spending over the month.

The latest capital account data recorded a broadly balanced position as there were investment inflows to compensate for flows out of Japan.

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The recent data has been mixed, although the net balance has certainly suggested an underlying slowdown in the economy. Sterling will gain initial support from expectations that the Bank of England will be reluctant to cut interest, especially as the US rate cut has improved Sterling yield support. There are still very high risks associated with the housing sector. Any significant deterioration and wider economic stresses would force the Bank of England's hand and, in these circumstances, Sterling sentiment would be liable to weaken sharply.                     
 
Sterling again found support weaker than the 0.70 level against the Euro while the UK currency scaled fresh 26-year highs above the 2.08 level against the dollar.

The UK CIPS index for the manufacturing sector weakened to 52.9 in October from a revised 54.7 the previous month. Consumer confidence weakened in the latest month to -8 from -7 in September. The CBI retail survey weakened to an 11-month low.

There was mixed evidence on the housing sector with the Nationwide Bank recording a 1.1% increase in prices for October while the Hometrack survey was more downbeat. Mortgage approvals fell to a two-year low in September, but consumer lending held firm over the month.

Bank of England MPC member Blanchflower stated that there were reduced wage pressures and that inflationary pressure was easing. MPC member Barker was more cautious over the need for a cut in interest rates while chief economist Bean warned that the bank must not be complacent over inflation risks.

Swiss franc

The Swiss economic data has held firm and the evidence suggests that domestic companies are gaining market share as there has not been the evidence of a significant slowdown which has been seen in the Euro-zone data. The National Bank has also continued to warn against franc weakness with the potential for a December interest rate increase. The Swiss currency will be sold if there are sustained gains in stock markets, but caution is likely to prevail over the next few weeks which will provide important Swiss protection.      
 
The Swiss franc fluctuated against the Euro during the week, but had a net firmer bias. The franc also tested two-year highs below 1.16 against the dollar with evidence of a tough battle around this level.

The Swiss KOF index held steady in October with a reading of 2.02 from a revised 2.04 the previous month while the latest consumption index also held firm.

Swiss consumer prices rose 0.9% in October with the annual inflation rate rising to 1.3%. National Bank President Roth stated that the bank would act if franc weakness against the Euro posed a threat to price stability. These warnings were repeated by bank member Jordan

The franc moves were again correlated strongly with movements in global stock markets with Wall Street losses pushing the franc stronger.

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The Australian dollar pushed to fresh 23-year highs against the US dollar after the US Federal Reserve interest rate decision, but then dipped sharply as global equity markets came under pressure.

Retail sales rose 0.8% in September while there was a 1.2% increase in private-sector credit and a 6.8% increase in building approvals. The firm data maintained expectations of higher interest rates. Indeed, markets priced in over a 90% chance that the Reserve Bank will increase rates next week

The trade deficit was higher than expected at AUD1.9bn for September as exports fell 4.0% over the month.

The Australian dollar will look to gain further short-term support on yield grounds, although capital flows could be increasingly volatile if trade fears increase and failure to increase rates would undermine the local currency.

Canadian dollar

The Canadian dollar strengthened to the highest level since the currency was floated freely in 1970 and hit a high near 0.94 against the US dollar.

The Canadian GDP growth was reported as 0.2% for September as the oil sector remained solid. There was a drop in producer prices for the month due to persistent currency strength.

The government warned over the impact of currency strength with Finance Minister Flaherty stating that much of the gains were due to speculative inflows.

There will be an increased risk of central bank action to weaken the currency given potential damage to the manufacturing sector with volatility liable to increase.

Indian rupee

The rupee held generally strong over the week with highs close to 39.22 against the US dollar which was the strongest level since March 1998.

The evidence suggested that capital inflows were generally firm over the week which helped underpin the currency. The central bank again intervened in the market to curb rupee gains. Increased credit-related stresses weakened the rupee to 39.45 against the US currency on Friday.

The export data offered some reassurance with a 19% annual increase in the year to September, although there were warnings over future trends given the rupee gains.

The rupee will gain support if there are further sustained capital inflows, although volatility will be a key risk over the next few weeks given that international capital flows are liable to be increasingly unstable. 

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The Hong Kong dollar again tested the 7.75 level against the US dollar during the week which is the strongest permitted point in the trading band. There was further intervention by the HKMA to prevent the currency moving through this level with dollar sales over US$1.0bn.

The HKMA stated that there were no plans to revalue the currency or widen the trading band. There were still rumours that China would effectively sanction a policy change within the next few months.

HKMA interventions lowered market interest rates sharply and this helped underpin the US currency with tentative arbitrage buying and this weakened the Hong Kong dollar to 7.7615 on Friday.

The Hong Kong dollar will not be able to strengthen beyond 7.75 against the US dollar unless there is a revaluation of the currency or a wider trading band.

Chinese yuan

The yuan remained generally firm during the week with the Chinese currency pushing to fresh post-float highs beyond the 7.46 level against the US dollar. The central bank was also comfortable with guiding the domestic currency stronger.

The Chinese authorities announced that restrictions on capital outflows would be lifted to help re-balance the capital account. The current account surplus widened to US$162bn in the first half of 2007 from around US$90bn the previous year.

The government announced increases in fuel prices which increased the underlying inflation fears and maintained speculation over higher interest rates.

There will be further underlying pressure for a stronger yuan. The most likely outcome is for a gradual advance, although there is certainly a significant chance that a one-off revaluation will be sanctioned.