Weekly Forex Currency Review 04-01-2008

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The US economy will remain a key focus of attention and there will be further fears over a slide towards recession which will tend to keep the dollar on the defensive. Growing doubts over growth prospects in other major economies should provide some important degree of dollar protection. Some corrective recovery in carry trades is realistic after recent losses even though investor caution will persist.                   

Key events for the forthcoming week

Dollar:

There will be persistent fears over the US economy in the short-term, especially with the housing sector still contracting and the latest ISM report will be of particular concern. The Federal Reserve will remain under strong pressure to cut interest rates further which will tend to undermine the dollar. There will be investment flows into the US and fears over global growth conditions are likely to provide some degree of dollar support with potential defensive inflows. Overall, the US currency will remain vulnerable in the short-term, but should be able to avoid heavy selling pressure from current levels.     
      
The dollar was unable to break the 1.43 level against the Euro ahead of the Christmas holiday and retreated back to lows beyond 1.4750 at the beginning of 2008 as underlying economic fears persisted. The trade-weighted index also drifted back towards the lows seen in late November.

The ISM index for the manufacturing sector fell sharply to 47.7 in December from 50.8 the previous month. This was the first reading below 50.0 for 11 months and the lowest reading since April 2003.

The economic data has been generally disappointing with only a marginal gain in durable goods orders for November and a further decline in house prices in the year to October, although existing home sales did stabilise for November.

The ADP employment report recorded a slower increase of 40,000 in December from a revised 173,000 increase the previous month while jobless claims edged lower to 336,000 in the latest week.

The minutes from December's FOMC meeting stated that there was an unusual amount of uncertainty surrounding the outlook. Members also stated that credit and economic risks could require substantial easing and that there had been a marked deceleration in consumer spending.

Markets continued to price in a further interest rate cut at the January FOMC meeting and there was some increased speculation over a 0.50% move following the weaker than expected ISM data.

The US dollar secured some support from a UAE announcement that it would maintain the existing currency peg, at least for the next 12 months.

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The ECB will remain uneasy over inflation trends and will want to retain a restrictive policy stance. The Euro-zone growth risks are liable to increase, particularly in vulnerable economies such as Spain. Any significant deterioration will significantly increase internal Euro-zone stresses and will also constrain the ECB policy options. Overall, the Euro should remain generally firm in the short-term, although underlying currency risks are likely to gradually increase.     

The Euro correction was completed ahead of the Christmas holidays and has secured renewed gains over the past 10 days. There has, however, been a significant divergence over the past few days with advances against the dollar and Sterling offset by losses against the low-yield currencies such as the yen.

The PMI indices suggested an underlying slowdown in growth. A key feature was divergence with Spain and Italy recording figures below the 50.0 level.

The German inflation rate edged down to 2.8% in December from 3.1% the previous month, but ECB officials were still concerned over potential inflation trends.

Euro-zone money supply growth remained high at an annual rate of 12.3% in the year to December which maintained the recent trend of strong expansion.

Following a huge liquidity injection over the New Year period, the ECB started to drain funds from the money markets in the first week of January.

Yen:  

The Japanese economy is unlikely to make any significant headway in the short-term with the Bank of Japan keeping interest rates on hold. The Japanese currency will gain some support if the Chinese currency continues to strengthen, but global risk factors are liable to remain dominant. As Japanese markets re-open, there will be some scope for renewed yen retail selling. Underlying caution is liable to prevail given the global credit tightening and the yen still has scope for underlying gains despite a near-term correction weaker.  
                    
The yen has strengthened sharply over the past two weeks. From levels near 114.0 against the dollar, the yen pushed to highs around 108.30. The Japanese currency also strengthened to near 160.0 against the Euro and advanced to a 14-month high against Sterling before correcting back to 109.30 against the dollar

Japanese markets were closed for an extended period over the New-Year period with no major domestic economic developments. With markets closed there was less evidence of Japanese retail yen selling to invest in overseas high-yield securities and this provided some yen support.

The geo-political fears surrounding Pakistan provided some degree of yen protection on safe-haven demand. The Japanese currency drew some support from the faster Chinese yuan appreciation against the dollar during the first few days of 2008.

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Confidence in the economy will remain weaker in the short-term with fears over a substantial deterioration in conditions as the housing sector comes under sustained pressure. In this environment, the Bank of England is likely to cut interest rates several times during 2008 despite the residual inflation fears and a January move is still a possibility. The net trend is likely to be for a further Sterling retreat, although there should be scope for some significant correction after heavy losses during the past month.   
 
Sterling secured brief recoveries at times, but the general tone has been weaker and selling pressure has accelerated over the past few days. The UK currency has weakened to record lows against the Euro near 0.75 while Sterling also dipped to lows below 1.97 against the dollar.

Confidence in the economy has deteriorated with increasing fears over the implications of a rising debt burden with increased speculation over a recession.

The UK PMI index for the manufacturing sector fell to 52.9 in December from 54.3 the previous month which suggested an underlying slowdown in the industrial sector. The services-sector data recorded a recovery to 52.4 from 51.9 while consumer lending was firm for the month

The Bank of England in its quarterly survey reported a tightening of credit within the mortgage sector while corporate conditions were also tighter with greater restrictions expected to remain in force during the first quarter of 2008.

The Nationwide Bank survey recorded a further decline in house prices for December while mortgage approvals also slowed sharply over the year.

Markets are expecting interest rates to be cut this quarter, but speculation over a January cut eased slightly following Friday's data.

Swiss franc:

The Swiss economy should continue to register a firm expansion in the short-term even with the potential for an underlying slowdown in growth. Swiss franc moves will continue to be influenced strongly by levels of risk aversion and underlying caution over carry trades will help underpin the currency. Risk appetite will recover at times which will trigger intermittent corrections weaker and the franc will find it difficult to extend recent gains.            
 
The Swiss franc found support close to the 1.16 level against the dollar late in December and has gained rapidly to levels near 1.11 in the first week of January. The Swiss currency also strengthened to highs beyond 1.64 against the Euro.

The Swiss currency gained some defensive support from an increase in risk aversion at the beginning of 2008 as global stock markets came under pressure.

Domestically, the KOF leading index held firm at 1.99 for December from 2.02 the previous month while the consumption index was weaker over the month

Consumer prices rose 0.2% in December with the year-on-year inflation rate rising to 2.0% from 1.8% which will keep the National Bank of inflation alert.

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The Australian dollar found support above the 0.8550 level against the US dollar in late December and pushed back to challenge levels above 0.88 as the US currency came under fresh pressure.

The domestic PMI and credit indicators were firm for month which reinforced confidence in the domestic economy. Markets were still looking for an interest rate increase during the first quarter of 2008, although the chances of a February increase was cut to around 30% as credit conditions tightened.

The Australian currency was hampered by a retreat from carry trades and there were significant losses against the Japanese currency.

The Australian dollar will look to gain support on yield grounds, but the increasingly difficult global growth environment will make it difficult to make much headway with the threat of net losses over the next few weeks as a whole.

Canadian dollar:

The Canadian dollar strengthened to near 0.9750 against the US currency late in 2007, but was unable to sustain the gains and weakened back to levels around 0.99 even though the US currency was generally weak.

There was little in the way of domestic data to steer the currency. Bank of Canada Governor Dodge stated that Canadian dollar appreciation had been justified due to an improvement in the terms of trade, but that the currency gains had been excessive.

The currency drew some support from the record level of oil prices and firm commodity prices, but still found it difficult to make much headway.

Overall, the Canadian dollar will find it difficult to make much headway against the US currency despite the beneficial impact of high oil prices.

Indian rupee:

The rupee edged stronger over the week and strengthened to around 39.35 against the dollar on Friday as rupee confidence improved. Although the currency was unsettled by retreats in global equity markets, selling pressure was contained as confidence in the Indian economy remained firm.

There was evidence of rupee buying in conjunction with the forthcoming Reliance Power IPO which curtailed US dollar demand over the week.

Reserve Bank Governor Reddy stated that the bank was aiming for increased rupee flexibility which sparked some market speculation that the bank would tolerate faster rupee gains over the next few weeks.

The rupee will still find it difficult to secure further short-term gains given the risk that growth and credit fears will undermine wider emerging markets.

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The Hong Kong dollar continued to weaken and hit a fresh four-month low around 7.8160 against the US dollar during Thursday and was unable to secure more than a limited recovery.

The local currency was undermined by renewed arbitrage activity with one-month interest rates falling to 2.85%.

The Hong Kong dollar was also unsettled to some extent by a retreat in global stock markets, although selling pressure was generally contained.

Overall, the Hong Kong dollar should be able to find support stronger than the 7.82 level against the dollar as arbitrage activity will decline sharply close to this level.

Chinese yuan:

The Chinese yuan continued to strengthen over the week with gains to near 7.27 against the US currency on Thursday. There was further evidence that the central bank was allowing a faster rate of currency appreciation at the beginning of 2008.

There was some evidence of profit taking in the NDF market which may also curb aggressive yuan buying, although underlying sentiment should remain firm.

There was a significant shift in interest rates with one-year Chinese interest rates moving above equivalent US rates for the first time since the 2005 currency float.

The underlying fundamentals will continue to promote steady yuan appreciation, especially with speculation that the bank will sanction faster gains. There will, however, be unease over global and domestic growth trends which may curb capital inflows and slow further yuan gains.