Weekly Forex Currency Review 02-12-2011

The Euro-zone debt crisis will continue to dominate in the short-term, especially with a key summit meeting at the end of next week.  The key European leaders do have a strategy for moving forward with the possibility of increased support for peripheral economies conditional on a commitment to tougher fiscal discipline. There will still be major political barriers to any deal and major doubts whether it will be sufficient to ease market pressures with high volatility likely to be the key feature.

Key events for the forthcoming week

Dollar:

The latest US economic data has maintained a more confident tone and increased hopes that the economy can resist a fresh downturn.  The situation will remain fragile and there will certainly be fears that Euro-zone turbulence could have a serious negative impact. There will also be a high degree of unease surrounding the budget situation.  The Federal Reserve will keep interest rates extremely low and will also consider further action if required which will curb dollar support. Defensive considerations will remain extremely important and any reduction in fear surrounding the Euro-zone and global liquidity would lessen dollar demand. Nevertheless, underlying support is likely to remain solid for now.

The dollar maintained a firm tone initially, but demand weakened following the central bank move to boost dollar liquidity.
 
Risk appetite was boosted initially by the Chinese central bank decision to cut reserve ratio requirements with the move intensifying sharply following co-ordinated action by the global central banks. The Federal Reserve and other central banks announced that they would cut the cost of dollar swap rates and increase liquidity in the market. The net impact of this will be to make dollar borrowing less costly and make it easier for banks to access funding,  lessening the threat of a major banking-sector collapse.

The US economic data was again better than expected with an ADP private-sector employment increase of 206,000 for November from a revised 130,000 while the Chicago PMI index rose to 62.6 from 58.4 and pending home sales rose strongly.  The data increased optimism that there would be a solid employment report on Friday.

The PMI manufacturing data was also stronger than expected with an increase to 52.7 for November from 50.8 previously and there was a significant recovery in both the orders and prices components which continued to suggest that the economy is making some headway. The dollar impact will again be mixed as potential yield support would be offset by reduced defensive demand for the US currency.

Regional Fed President Bullard hinted that there would be no major policy moves at the December FOMC meeting, although there was increased speculation that there would be a technical cut in the discount rate. Fitch maintained its AAA rating for the US, while lowering the outlook to negative from stable, reminding markets over the very fragile US deficit situation

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The Euro-zone situation will remain extremely serious with recession fears also acting to intensify fears surrounding sovereign debt issues.  Measures to boost liquidity will have some positive impact, but there will still be a high degree of fear surrounding solvency. There will be strong pressure for the ECB to cut interest rates again and take a more aggressive stance in buying peripheral bonds.  Further action may be possible, but the ECB and German government will demand very strong assurances on budget policies and there will certainly be major fears that action will be insufficient to prevent a Euro break-up.

The Euro retreated back to the 1.33 area during the New York session on Tuesday before recovering as risk appetite was boosted and sentiment improved slightly.

In its latest money-market operations, the ECB failed to attract sufficient bids and the latest SMP bond purchases were, therefore, not fully covered. The move increased speculation that the ECB would effectively have to move to quantitative easing. There were also further expectations of a cut in ECB interest rates.

Euro-zone Ministers agreed that the first 25-30% of new bond issues would be insured as part of their efforts to leverage the fund, although there was a widespread recognition that the EUR1trn target would be out of reach. There were also suggestion of talks with the IMF which could lead to additional support for peripheral economies.

There was a flurry of political rhetoric ahead of next week’s EU Summit as French President Sarkozy in particular warned over the efforts required to prevent a break-up of the Euro area with a call for Treaty changes. There was a clear warning from political and banking figures that the moves to boost liquidity will help ease immediate tensions, but that there are still severe structural difficulties.

The underlying plan still appears to be that major leaders will seek political concessions from the Euro-zone countries which would push them much closer to rapid fiscal integration. In return, there will be increased support for peripheral economies. The ECB also suggested that if there was a move to guarantee fiscal rules then the ECB would consider providing additional support. Tensions will inevitably increase ahead of next week’s summit given fears that failure or an inadequate response would trigger a terminal escalation of the crisis.

Yen:

Safe-haven considerations will remain extremely important in the short-term and there will be underlying defensive support for the Japanese currency, especially with a lack of viable alternatives given the continued Swiss determination to block currency gains.  There will also still be the potential for capital repatriation by major institutions. There will be domestic pressure to weaken the yen, especially if there is a downturn in the regional economy which would undermine exports and increase fears over the long-term manufacturing trends.

The dollar was able to find support on dips towards the 77 level against the yen during the week, but struggled to gain strong support as both currencies moved in tandem.
 
The latest Japanese capital spending data was weaker than expected with a 9.8% decline for the third quarter after a 7.8% fall the previous three months which will maintain fears over a structural lack of demand within the economy.

There will be some reduction in defensive yen demand if global central banks can foster a mood of increased confidence, but funds will inevitably remain very cautious in the short-term and there is little prospect of aggressive overseas-securities buying.

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Confidence in the UK economic outlook is liable to deteriorate further with fears over the impact of a downturn in the Euro-zone. The fiscal outlook has weakened further and there will be severe debt implications if there is a move back into recession. There will also be speculation over additional Bank of England quantitative easing once the current round of bond purchases is completed in February.  There could be further near-term defensive Sterling demand as an alternative to Euro-zone assets, although these flows would be in severe jeopardy in the event of a credit-rating downgrade.

Sterling was subjected to choppy trading conditions during the week and Euro/dollar moves tended to dominate as the UK currency made some headway against the dollar with a temporary move above 1.57, but failed to sustain an advance against the Euro.

In its Autumn Budget Statement, the government was forced to admit that the economic outlook was significantly worse than expected. The OBR stated that GDP growth was likely to be 0.9% this year following by 0.7% next year and this will inevitably put upward pressure on the budget deficit with borrowing set to be at least GBP100bn higher than expected over the next five years.

The immediate market impact was measured as the adjustments were broadly in with expectations. There was, however, a statement from ratings agency Fitch that the revised UK projections involved a significant deterioration and there was a clear warning that the credit rating could come under pressure. A downgrading would pose very substantial risks to UK confidence and Sterling.

The UK economic data was weaker than expected as the CBI retail sales survey weakened to the lowest level since the first quarter of 2009 at -19 for November from -11 previously. The PMI manufacturing index dipped to the lowest level since July 2009 at 47.6 from a revised 47.8 previously. There was a further downturn in orders and the rate of decline in employment was also the highest for over two years.

Following the latest Financial Stability Review, Bank of England Governor King again warned over the risk of a renewed credit crunch in the economy and also warned in uncompromising terms over the dangers posed by the Euro-zone crisis.

Swiss franc:

The National Bank will remain determined to protect the minimum Euro level against the franc with further strong verbal intervention and the potential for franc selling in the forward market.  There have also been hints that the bank could make official interest rates negative in an attempt to deter capital inflows. There will be the risk of a renewed surge of capital into Swiss institutions if Euro-zone fears intensify and the bank’s policies could still be severely tested. High volatility is likely to remain the most notable feature.

The Euro found support on dips towards 1.2250 against the franc and rallied back above the 1.23 level as the dollar also again found support below the 0.91 level.

The PMI index dipped further to 44.8 for November from 46.9 previously. The KOF business confidence index weakened to 0.35 for November from a revised 0.75 previously which will maintain fears over a further deterioration in the economy. National Bank Chairman Hildebrand stated that the franc was still very highly valued and that he expected the currency to weaken further in the medium term.

The government warned that it would consider supporting pushing interest rates into negative territory to help the National Bank combat any fresh strengthening of the Swiss currency and talk of negative interest rates inevitably pushed the franc weaker.

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The Australian dollar advanced strongly with gains to a high of 1.03 against the US currency with a firm rebound from November lows. Trends in risk appetite remained dominant and there was an important improvement in conditions as global banks looked to boost liquidity and defensive US currency demand fell.

Domestic economic data was mixed, with a slightly weaker tone as there was a weaker than expected increase in retail sales and a second successive sharp decline in building approvals, although new home sales increased.

The Australian dollar will gain support from an improvement in risk appetite, but the underlying conditions will make it difficult to secure significant further gains.

Canadian dollar:

The Canadian dollar found support in the 1.05 area against the US dollar and strengthened significantly to highs beyond 1.02. Risk conditions continued to have an important market impact and an improvement in conditions significantly strengthened demand for the Canadian currency.

The latest GDP data was slightly weaker than expected, but did not have a significant impact as international trends were dominant.

The Canadian dollar will be vulnerable to further selling pressure given the global risk conditions, especially as industrial commodity prices will be at risk of further losses.

Indian rupee:

The rupee remained under pressure at the start of the week, testing fresh record lows, but there was a significant shift following the global central bank move to boost dollar liquidity.  The Indian currency recovered to the 51.50 area against the US currency as risk appetite improved and the dollar retreated in global markets.

There was also some positive impact from the Reserve Bank efforts to boost capital investment flows, although there was still an underlying mood of caution.

The rupee trends will continue to be influenced strongly by trends in risk appetite and it will be difficult to secure more than a limited recovery in the short-term.

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The Hong Kong dollar found support just weaker than the 7.7950 level against the US currency early in the week and advanced strongly during the week as a whole with the currency advancing to highs just beyond 7.7680.

There was an important shift in sentiment following move to boost liquidity.  There was a significant decline in defensive flows into the US currency which supported the Hong Kong dollar.  The cut in Chinese Reserve Ratio Requirements also had a significant impact in boosting risk appetite which also underpinned the currency.

Risk conditions will continue to dominate Hong Kong dollar moves with only limited gains realistic, especially if there is evidence of further weakening in the mainland.

Chinese yuan:

Yuan volatility stayed higher as domestic and international factors had an important impact. After initial weakness, the PBOC pushed the currency sharply higher. There was a reference rate of 6.335 against the dollar, but there was still evidence of firm US demand as the yuan was at the weakest level of the permitted band.

There was a weaker than expected reading for the PMI index with the official index declining to 49, increasing unease surrounding the economy.  In response to evidence of weaker demand there was a cut in the Reserve Ratio Requirement of 0.50%.