Weekly Forex Currency Review 05-08-2011

Fear is likely to be the dominant short-term influence. There will be sharply increased concerns over the global economy and there will also be further fear surrounding the Euro-zone as the contagion effect threatens to spread to core economies. There will be pressure for much more decisive action by European governments and there will also be speculation over additional quantitative easing by the Federal Reserve with high volatility.

Key events for the forthcoming week

Dollar:

Although there will still be fears over a credit-rating downgrade, there will be relief that the US debt-default risk has been removed and this will allow the dollar to gain defensive capital inflows when risk appetite deteriorates and liquidity dips. There will be concerns over the economic outlook following a run of generally disappointing data and there will be further speculation that the Federal Reserve will consider further quantitative easing in order to support the economy, especially if there is another weak employment report. In this environment, underlying confidence in the dollar will still be limited and it will remain dependent on weakness elsewhere to make strong headway.

The dollar secured strong net gains for the week with rapid appreciation against commodity currencies as growth fears increased.  There was a rise in Libor rates and fears over a banking crisis in Italy which triggered further defensive demand for the dollar. The Euro also fell sharply, but did find support below 1.41.

After a weekend breakthrough on the US debt talks, the House of Representatives did pass the compromise budget deal which sanctions an increased debt ceiling. The US Senate comfortably approved the US debt-ceiling legislation and Obama’s signing of the bill formally removed any default threat. Moody’s affirmed its AAA credit rating for the US while Fitch stated that the situation was still under review.

The US ISM index for the manufacturing index was sharply weaker than expected with a decline to 50.9 for July from 55.3 the previous month and the lowest since June 2009.  The much weaker than expected data undermined confidence in the US economy and also had an important impact in damaging risk appetite.

The ISM index for the services sector dipped to 52.7 for July from 53.3 the previous month, maintaining concerns over the economy. As far as the components were concerned, there was a weak reading for orders and the employment index.

The US jobless claims data was slightly better than expected with a dip to 398,000 in the latest week, but the impact was overshadowed by a sharp decline in equity markets as fear over the economy increased. There was fresh speculation over a fresh Federal Reserve move to expand quantitative easing given the run of disappointing data and the Friday employment report will be watched very closely.

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Underlying confidence surrounding the Euro-zone economy will remain weak in the short-term with further fears over the contagion risk as investors flee the more vulnerable economies. The implications of severe stresses within Italy and Spain will be particularly damaging as EU governments do not have the funding available to provide an effective support mechanism for these countries. If the contagion threat cannot be eased, there will be further speculation over a break-up of the Euro area.  There will still be Euro support from strength in Germany and speculation over the eventual emergence of a new ‘hard-Euro’ zone.  Nevertheless, the currency is likely to remain vulnerable in the short-term.  

There was a further increase in Euro-zone tensions during the week with a sharp widening in peripheral yield spreads. Italian yields rose to 14-year highs while Spanish yields also rose sharply. Italian officials held emergency meetings on Wednesday while Spanish Prime Minister Zapatero also stated that holiday plans would be postponed to monitor the economic situation.

There was further speculation that an expansion of the EFSF would be required, but this would run into heavy political opposition and markets doubted the commitment for a near-term increase, especially from Germany.

There was no surprise in the ECB interest rate decision with rates left at 1.50%. At the press conference following the meeting, there was still some tough talk on inflation from President Trichet, but he also stated that the growth outlook had deteriorated.

The ECB announced the provision of unlimited liquidity through six-month financing operations and also announced the resumption of peripheral bond buying. The ECB buying was confined to Ireland and Portugal with no action in the crucial Spanish and Italian bond markets. This division caused major doubts over the ECB commitment which undermined market confidence. The German Bundesbank opposed the decision and sources indicated that there were other votes against the move.

In this environment, sentiment deteriorated and there was a fresh widening in peripheral spreads which triggered sharp Euro losses. There were negative comments from EU commission head Barroso and Italian Finance Minister Tremonti which criticised the official response to the Euro-zone crisis.

Yen:   

The yen will continue to gain some defensive support from a lack of confidence in the US and Euro-zone economies and the yen will also continue to gain defensive support if wider confidence in the global economy deteriorates further. There will be the potential for further Bank of Japan intervention, but the effectiveness will be limited if there is no wider G7 backing for the move. There will be fears over the Japanese fundamentals given the weak long-term outlook, but defensive considerations will tend to dominate in the short-term.    

The yen weakened sharply during the Asian session on Thursday as the Finance Ministry confirmed that it had sanctioned intervention through the central bank. Japan acted alone on the intervention, but did consult with other G7 members.

The latest monetary-policy meeting was brought forward 24 hours to Thursday forward with the Bank of Japan leaving interest rates on hold at 0.00-0.10%. The central bank increased the amount of quantitative easing to JPY50trn from JPY40trn and the yen weakened to lows near 79.50 against the US currency.

The Bank of Japan briefly managed to push the yen weaker than the important 80 level against the dollar. Official amounts will not be revealed for some weeks, but there were estimates that as much as JPY4trn had been sold.

Risk conditions deteriorated again during the New York session on Thursday which triggered fresh defensive demand for the Japanese currency as equity markets fell sharply. Confidence remained extremely fragile in Asia on Friday and the yen secured further support with gains back to the 78.50 area. Markets will watch the G7 response very closely both on Friday and over the weekend.

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There will be further concerns over the growth outlook, especially as weaker global growth will make it even more difficult for the UK to boost exports. There will be relief over the recent services-sector data which should prevent any immediate move towards further quantitative easing, but there will still be expectations of extremely low interest rates which will limit support. The currency will also tend to weaken when risk appetite deteriorates, limiting the protection from weakness in the Euro area. Any Sterling selling pressure could be intense if there are renewed stresses within the banking sector.

Sterling was blocked above 1.64 against the dollar during the week and weakened to lows near 1.6220 as Euro losses triggered a US advance against Sterling. The UK currency did secure net gains against the Euro with a two-month high near 0.8650.

The UK PMI manufacturing index was sharply weaker than expected with a decline to 49.1 for July from a revised 51.4 previously and this was the lowest level for over two years.  In contrast, the services-sector report was stronger than expected with an increase to 55.4 for July from 53.9 the previous month which was the highest reading since March and helped ease immediate fears over the economy.

Given the high degree of stresses within global markets and fears surrounding the Euro-zone, the Bank of England interest rate decision went almost un-noticed.
The MPC left interest rates unchanged at 0.50% while the amount of quantitative easing was also left on hold at GBP200bn with no statement.

The financial sector will remain under close scrutiny in the short-term as banking-sector shares continue to fall sharply. If there is any further widening in interbank spreads, then the net cost of borrowing will increase which will further damage the economy and could force additional Bank of England quantitative easing.

Swiss franc:

The National Bank action to cut interest rates illustrates the depth of concern over the strong franc and further more extreme policy measures will be considered. Nevertheless, the franc will continue to be influenced very strongly by the Euro-zone stresses and degrees of risk appetite within global markets. If confidence in the Euro-zone peripheral economies continues to weaken, then there will be further defensive inflows into the franc. High volatility is likely to remain the key short-term market feature.  

The Swiss franc weakened sharply in European trading on Wednesday as the National Bank finally took action on the currency. The central bank cut the repo rate to a range of 0.00-0.25% from 0.25% previously, aiming for a rate as close as possible to zero. The bank also added additional liquidity into the market and promised that further measures would be taken if necessary to combat extreme franc over-valuation.

The dollar was unable to regain the 0.78 level against the franc on Thursday and weakened sharply to lows near 0.76. There was an even sharper move for the Euro which weakened to near 1.07. Fear dominated markets during the European and US sessions and this triggered a fresh wave of safe-haven franc buying as equity markets fell sharply and Euro-zone peripheral spreads widened.  Signs of disarray within the European authorities were particularly important in triggering fresh franc demand. Bank President Hildebrand warned that further action could be taken

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The Australian dollar was unable to sustain a move above the 1.10 level against the US dollar during the week and fell very sharply to lows below 1.05 as a deterioration in global risk appetite was compounded by unease over the domestic economy.

The domestic economic data offered no real support for the currency as all the PMI business confidence surveys remained entrenched below the 50 level. There was a sharp decline in home sales and building approvals while retail sales also fell again.

The Reserve Bank left interest rates on hold at 4.75% and was more cautious over the growth outlook, although it also maintained unease over inflation The international risk profile is liable to deteriorate further on growth fears with the Australian dollar likely to remain on the defensive in the short-term.

Canadian dollar:

The Canadian dollar hit resistance stronger than 0.95 against the US dollar during the week and dipped sharply over the second half of the week with lows beyond 0.98

The catalyst for the rapid move was a major deterioration in risk appetite with fears over the global outlook triggering sharp declines in equity markets. There was also downward pressure on commodity prices which undermined the Canadian currency. There were no major domestic developments during the week.

Although the fundamentals should remain broadly favourable, the Canadian dollar is likely to be undermined by reduced tolerance of risk and global growth fears.

Indian rupee:

The rupee was unable to extend gains during the week and retreated to five-week lows beyond 44.75 later in the week. The currency was undermined by a general deterioration in risk appetite and decline in global stock markets as fears over the global economy increased. The local currency was still broadly resilient amid optimism that capital inflows would hold-up relatively well.

There were further concerns over the impact of rising food prices which maintained the potential for further increases in official interest rates.

Although the currency should be able to remain resilient, there is little chance of gains without an improvement in global risk appetite and recovery in growth hopes.

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The Hong Kong dollar initially held steady at the start of the week, but then came under significant selling pressure with lows beyond the 7.80 level.

The Hong Kong currency was undermined by a serious general deterioration in risk appetite as global equity markets were subjected to heavy selling pressure.

There was longer-term speculation that the currency peg would be broken, but this was overshadowed by the shorter-term market concerns.

The Hong Kong dollar trend will remain closely correlated with risk appetite and it will tend to remain vulnerable in the very short-term.

Chinese yuan:

The Chinese yuan was little changed over the week as a whole and consolidated just weaker than the 6.44 level as the currency did not follow the central bank’s stronger fixings as the weaker Euro late in the week also underpinned the US dollar.

Currency regulator SAFE commented that capital inflows were likely to weaken over the second half of 2011 and there were further concerns over the economic outlook. There was further speculation that bad-debts within the local government sector could help trigger a sharp slowdown in the economy.

There is likely to be increased unease over the threat of a hard landing in the economy and speculation that the yuan could actually weaken over the next few months.