Weekly Forex Currency Review 04-05-2007

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Overall strategy

Confidence over the US economy is likely to remain slightly stronger in the short-term, but the dollar will need more decisive evidence of a recovery in growth and significantly improved yield spreads to secure a more durable rebound. Volatility levels are liable to increase over the next few weeks given the threat of complacency over US global risk conditions.

Key events for the forthcoming week

Dollar

Concerns surrounding the US economy have eased very slightly following the US data this week, but the markets will need a series of stronger data to trigger a more sustained recovery in sentiment. The Federal Reserve statement will be watched very closely next week and interest rates are likely to be unchanged while a restrictive statement would help support the dollar. The yield structure will make it difficult to secure a strong recovery, but some further limited corrective dollar gains remains realistic.

The US currency again tested record lows early in the week before staging a recovery after the US economic data was generally stronger than expected.

The ISM index for the manufacturing sector recovered to 54.7 in April from 50.9 the previous month with the orders, employment and prices indices all rising strongly. There was a similar result for the services-sector index with an increase to 56.0 for April from 52.4 previously with business confidence generally stronger.

The Chicago regional PMI index was more subdued for the month while there was a 3.1% increase in factory orders. The ADP report recoded a subdued 64,000 increase in employment for April which ensured some caution ahead of the monthly payroll data. Jobless claims, however, fell to 305,000 in the latest week, a four-month low.

The core PCE inflation index was unchanged in March with the annual rate dropping to 2.1% from 2.4% the previous month. The first-quarter increase in unit labour costs was held to 0.6%, but the increase for the fourth quarter of 2006 was revised up to 6.2% from 3.8% which maintained concerns over inflationary pressure.

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Confidence in the Euro-zone economy will remain firm and there is still a strong probability that the ECB will increase interest rates at one of the next two council meetings. There is tentative evidence of a slowdown growth and the Euro will falter if there is evidence of a more serious deterioration, especially as any slowdown would increase pressure for Euro gains to be curbed through verbal intervention.

The Euro pushed to record highs against the yen during the week and strengthened to an eight-year high against the Swiss franc before a slight correction.

The Euro-zone PMI indices for the manufacturing and services sectors edged lower for April, although they continued to record a firm level of activity. Annual money supply growth also remained robust at over 10%.

There was a further reduction in German unemployment for April, but the 9,000 decline was much lower than the average monthly decline of over 50,000 seen over the previous few months.

European officials remained generally calm over Euro levels in comments during the week, although the ECB did state that the exchange rate would play some part in the interest rate setting process

Yen 

Yield considerations will remain very important in the short-term with the Japanese currency still vulnerable, especially given the persistent interest in carry trades. The low inflation data will also maintain expectations that interest rates will be held steady. There is, however, an increasing risk that the markets are being complacent over underlying risk conditions and there will be the potential for a sharp yen recovery, especially if trade tensions increase.    
                    
The yen remained on the defensive during the week with the yen testing support levels beyond 120.0 against the dollar and remaining weak against the Euro.

There was limited market activity during the week with Tokyo markets closed for 3 days for the Golden Week holidays.

In this context, there were no major economic data or domestic influences as international carry trades remained the dominant influence.

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There is a strong probability that the Bank of England will increase interest rates at the May MPC meeting. Overall confidence in the economy will also remain firm in the very short-term. The economic risks are continuing to build, however, with the housing sector in severe danger of weakening sharply. The net flow of merger-related funds is also now liable to be much less favourable for the UK currency which will be a very important factor and will increase the risk of gradual Sterling depreciation over the next few weeks.  
 
Sterling edged lower against the Euro during the week with lows around 0.6835. The UK currency was unable to hold above the 2.00 level against the dollar and weakened back to 1.9860 on Friday as the US currency gained ground.

The latest consumer data recorded an improvement in confidence for April while there was a strong reading in the latest CBI retail survey with the headline reading at a 3-year high.

Although activity was firm, the CIPS indices for the manufacturing and services sector both declined slightly over the month while the services-sector inflation component fell to a four-month low.

The mortgage lending and consumer lending data both suggested that activity was slowing slightly with mortgage approvals falling over the year.

Markets remained very confident over a May interest rate increase, but expectations over further increases were scaled back slightly.

Swiss franc

Swiss yields will remain low in nominal terms which will maintain the potential for franc selling if there is sustained interest in carry trades. The Swiss fundamentals will remain strong and the rise in inflation will increase National Bank unease over franc weakness against the Euro. The central bank will also increase interest rates again in June. The Swiss currency is liable to correct sharply stronger if there is a sustained increase in risk aversion.
 
The Swiss franc weakened beyond the 1.65 level against the Euro and was again unable to break through the 1.20 level against the dollar.

The Swiss PMI index edged marginally lower to 61.9 for April from 62.0, although this was still at an historically high level.

There was a 1.1% increase in Swiss consumer prices for April with the annual inflation rate rising to 0.5%. The monthly increase in prices was the strongest increase for over 15 years as import prices rose strongly.

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The Australian dollar was unable to hold above the 0.83 level against the US dollar during the week and weakened back to below the 0.82 level in local trading on Friday.

The Reserve Bank held interest rates at 6.25% following the latest policy meeting. The bank lowered its core 2007 inflation target to 2.5% from 2.75% in the latest monetary report which curbed expectations over higher interest rates later this year.

The PMI indices edging stronger for April while the March trade deficit rose to AUD1.62bn from AUD0.77bn in February on a temporary decline in iron-ore exports.

Canadian dollar

The Canadian dollar strengthened to highs around 1.1050 against the US dollar, maintaining the impressive run seen over the past month. The currency resisted more than a limited correction with further support from merger-related inflows.

The Canadian economic data remained generally strong with a 0.4% GDP increase for February which was led by a sharp rise in energy production. There was also a significant increase in producer prices for the month.

Bank of Canada Governor Dodge stated that the Canadian dollar had strengthened more than expected by the bank, but Dodge stated that there would be no short-term  intervention to restrain the currency.

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The Indian rupee was unable to sustain levels beyond 41.0 against the dollar early in the week and weakened to lows around 41.25 before strengthening to 40.92 on Friday.

The underlying tone has been of consolidation and correction following the rapid rupee gains seen during April.

Activity was limited by market holidays on Tuesday and Wednesday. There was increased demand for dollars from oil importers which underpinned the US currency.

There were increased market fears that the Reserve Bank would look to weaken capital inflows by curbing overseas borrowing, but underlying capital inflows were still strong which underpinned the Indian currency.

The rupee should remain firm, especially with the bank uneasy over intervening, but there will be continuing pressure for a correction.

Hong Kong dollar

The Hong Kong dollar depreciated to lows beyond 7.822 against the US currency during the week and was holding just weaker than 7.82 on Friday.

The Hong Kong currency was supported slightly by a rise in local money-market rates as cash demand increased ahead of further IPO offerings over the forthcoming weeks.

There was also some evidence of corporate demand for the US dollar with the US currency also gaining support from higher US Treasury yields, although trading ranges were narrow.

The Hong Kong dollar is unlikely to make significant headway in the short-term.