Weekly Forex Currency Review 04-11-2011

The Euro-zone debt crisis has returned to dominate the headlines following Greek referendum announcement and subsequent withdrawal.  Tensions will remain extremely high with increased fears surrounding Italy maintaining severe doubts surrounding the Euro-zone as a whole. Ironically, capital repatriation fears could support the Euro initially, but the underlying foundations are liable to weaken further as capital flight from the periphery intensifies. High volatility is likely to be a key feature.

 Key events for the forthcoming week

Market analysis

Dollar: 

There will be some further hopes that the US economy can avoid recession, but underlying confidence will inevitably remain very fragile.  The Federal Reserve also remains concerned over the outlook and there will be further speculation that the central bank will sanction additional quantitative easing. The underlying fundamentals also remain weak given the severe budget stresses. International trends will remain extremely important in the short-term and there will be defensive dollar demand at times, especially if there is evidence of sustained deterioration in the global economy and a firm tone is likely.  Repatriation flows into Europe could, however, unsettle the currency to some extent.

The dollar secured significant net gains for the week against the Euro and gained strongly at times when risk aversion increased with a peak near 1.3650, although the underlying performance still lacked conviction.

The US PMI index for manufacturing dipped to 50.8 for October from 51.6 previously and there were mixed readings for sub-components as orders improved and inventories fell while there was a sharp decline in prices.

The Fed announced that policy was on hold following the latest FOMC meeting. The message of stability allowed Bernanke to secure a unanimous vote, especially as there was some discussion on amending language putting dates on how long policy would be on hold.

The third-quarter growth was described as stronger, but the Fed still pointed to downside risks for the economy and inflation. It will, therefore, stand ready to safeguard the economic recovery with further buying of mortgage-backed securities.

The decision not to sanction any immediate easing helped support the dollar with gains compounded by Euro uncertainty.

Subsequently, jobless claims falling to 397,000 in the latest week from  406,000 previously while the PMI services index was little changed at 52.9.

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Euro-zone tensions will remain extremely high in the short-term. Even though a Greek referendum looks to have been avoided, the underlying political situation remains precarious and there will be further speculation over a Greek Euro exit. The main danger to the Euro will come from the contagion threat, especially with increased fears surrounding Italy. So far, the ECB is continuing to resist an increased financing role, increasing the risk of disorderly capital outflows.  Ironically, the Euro cold actually strengthen initially in the face of increased fear as capital repatriation by the banking sector would be liable to increase. Nevertheless, the underlying outlook remains precarious.

The announcement of a Greek referendum had a very important negative impact on sentiment, especially as it put the Euro-zone Summit deal in severe jeopardy.  There was strong criticism from other European governments over the decision. There were fears that the EFSF would find it much more difficult to attract funds and there was little chance of Chinese investment given the prevailing uncertainty.

There were strong statements that Greece would not receive further aid until the issue of Euro membership had been resolved. The stakes were raised further by an EU threat that any decision to leave the Euro would also be a vote to leave the EU. Although the threat galvanised Greek political support, there was an increase in underlying fear surrounding the Euro-zone and Italian stresses increased, especially with the weak Italian government failing to commit over reforms.

Political tensions also remained extremely high in Greece following the announcement and prime Minister Papandreou was eventually forced to withdraw the plan after gaining a pledge of support over the austerity measures from the main opposition party.

There was an unexpected ECB interest rate decision with rates cut by 0.25% to 1.25%, the first since 2009. Incoming President Draghi justified the cut on the back of a weakening economic outlook and expectations of a mild recession by the end of 2011. In the press conference, Draghi adopted a generally orthodox stance on monetary policy. He strongly defended the bank’s current mandate and completely rejected the idea of the ECB being a lender of last resort. Italian and Spanish yields also retreated from peak levels, but Italian benchmark yields were still above 6.20% and there were continuing fears surrounding austerity measures within Italy.

There was a further strong suspicion of capital repatriation by weaker European banks which was putting underlying upward pressure on the Euro despite political and economic stresses.

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The Bank of Japan will remain an extremely important focus in the short-term following the decision to intervene aggressively to weaken the yen. There will be a further determination to protect competitiveness, especially with industrial production at risk of sliding again. There will be a reluctance to push capital overseas if global economic confidence continues to weaken and there will also be the risk of capital repatriation which would boost the yen. The currency may, therefore, prove resilient to wider losses in the short-term.

The dollar was unable to make any significant headway during Friday and drifted weaker with a test of record lows near 75.50 against the Japanese currency.

There was a rapid dollar move higher in Asian trading on Monday as a US decline to record lows finally triggered action by the Finance Minister. The Bank of Japan intervened aggressively in the market with large-scale yen sales. The Japanese currency weakened sharply to lows near 79.50 during the session which was a three-week high for the US currency.

The Finance Ministry warned that there would be further action if necessary which will curb immediate yen buying. The evidence suggested that intervention was unilateral and there were no co-ordinated moves by G7.

There were further reports that the Bank of Japan was intervening in small quantities to prevent any renewed appreciation for the yen. There will still be the risk of capital repatriation as Euro fears intensify which could trigger fresh volatility.

Sterling:

There will be further concerns over the UK economy with the latest surveys suggesting an important risk of a slide back towards recession, although there has been some evidence of resilience. Yield trends will remain extremely unfavourable for the UK currency. For now, Sterling will still have the potential to attract defensive inflows, especially with severe doubts surrounding the Euro-zone. The UK banking sector could still prove to be a source of extreme vulnerability, especially with pressure for European repatriation with high volatility likely to be a key feature.

Sterling again proved to be resilient during the week as it advanced against the Euro and found support below 1.59 against the dollar.

There was some relief surrounding the latest GDP data with a 0.5% increase for the third quarter following a 0.1% increase the previous quarter.  In contrast, the PMI manufacturing index fell sharply to 47.4 for October from 50.8 the previous month which was a two-year low for the index.

The latest PMI services-sector report was weaker than expected with a decline to 51.3 for October from 52.9 the previous month. There was an underlying mood of caution within the report and inflation pressures eased, although there was also an improvement in business confidence.  The NIESR also warned that there was at least a 50% chance that the economy would move back into recession as it cut growth forecasts for 2012 and confidence remained very fragile.

There were defensive capital outflows into the UK currency during the day as Euro-zone stresses continued to dominate during the day. There will still be fears surrounding the threat of capital outflows from the banking sector given pressure on European banks to raise funds.

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The National Bank will remain determined to protect the minimum Euro level against the franc in the short term. The Euro-zone trends will be watched very closely and any further increase in the contagion threat could still result in capital inflows and pressure on the minimum Euro level. There will be the threat of further market volatility in the short-term which will complicate the National Bank’s task, although it should be able to hold the situation in the short term.

The dollar found support below 0.86 against the franc early in the week and strengthened to near 0.90 before hitting fresh selling pressure. The Euro struggled to sustain any buying support against the Swiss currency during the week.

The Swiss PMI index weakened to 46.9 for October from 48.2, maintaining the sharp downturn seen during the previous few months. There will be further pressure on the National Bank to resist currency gains.

In comments on Thursday, National Bank member Danthine reinforced the determination to maintain the minimum Euro level and that the franc level was still very strong even with a minimum 1.20 Euro level. There were also comments that there would be additional steps to protect the economy from franc strength

Australian dollar:

The Australian dollar found was again subjected to high volatility during the week as international and domestic tensions dominated. From a peak above the 1.07 level, the Australian dollar was subjected to renewed selling pressure and there were lows in the 1.02 area. Domestically, markets expected a very close interest rate decision and, in the event, the Reserve Bank cut interest rates by 0.25% to 4.50% from 4.75%.

There were sharp fluctuations in risk appetite during the week with a high degree of stresses within global capital markets. There was a sharp deterioration in risk appetite as Euro-zone fears intensified again.

Australian dollar volatility is likely to remain high and it will be difficult for the currency to secure sustained buying support given the underlying risks.

Canadian dollar:

The Canadian dollar strengthened to highs near 0.99 against the US currency during the week and dipped to lows beyond the 1.0250 level as risk appetite deteriorated before consolidating in the 1.01 area in choppy trading conditions. There was general resilience in the currency even though there was general caution surrounding international risk appetite with oil prices generally firmer.

The tone of domestic data releases provided some support with stronger than expected GDP, although the Bank of Canada was generally cautious over the outlook for 2012.

The Canadian dollar will find it difficult to advance much beyond parity against the US currency, but should prove to be broadly resilient in the short term.

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The rupee continued to find support on dips towards the 50 area against the US dollar during the week, especially with some speculation that the Reserve Bank would intervene to provide support for the local currency.

There was optimism that the government would announce an increase in foreign investment limits which would encourage capital inflows. There were sharp fluctuations in risk appetite during the week which created fresh turbulence in the currency, although there was underlying resilience, especially with the Euro rebounding from lows.

The rupee trends will continue to be influenced strongly by trends in risk appetite.  The currency should be able to resist substantial losses from current levels.

Hong Kong dollar:

The Hong Kong dollar maintained a firm tone during the week and generally tracked close to the 7.77 area against the US currency.

The currency was supported by general tightness in liquidity within local money markets and there was a slowdown in domestic money-supply growth which provided support. There was some optimism over a soft landing within the Chinese economy, although markets remained generally cautious.

The Hong Kong dollar should remain resilient with initial support from tight liquidity and medium-term support from speculation over a peg revaluation.

Chinese yuan:

The PBOC continued to push for a stronger Chinese yuan and it pushed the currency to record fixings beyond the 6.32 against the dollar. The market was unconvinced by the move and was generally trapped close to the 6.35 level as importer dollar demand remained strong and markets remained unconvinced over the economic outlook.

A weaker than expected official PMI index which dropped to near the 50 level sparked fresh economic doubts. The Chinese currency policies remained a very important political focus and during the G20 meetings, the US Treasury stated that China had made a commitment to currency flexibility.

Yuan volatility is likely to remain higher despite PBOC determination to limit movement. Doubts surrounding the economy will limit the scope for appreciation.