Weekly Forex Currency Review 06-01-2012

After a brief respite during the holiday period, Euro-zone fears have increased again.  There will be continuing unease surrounding the bank-sector outlook and fresh speculation that the Euro area will be forced to break apart.  Global de-leveraging throughout the banking sector will be an important focus and should maintain underlying dollar demand during the first quarter.

Key events for the forthcoming week

Dollar:

There will be further cautious optimism over the US economy. Although the Federal Reserve will maintain extremely low interest rates throughout the year and will be prepared to take further action if necessary, there will be the potential for investment inflows, especially given doubts surrounding the European economies. Defensive considerations will remain extremely important for the US currency and there will be inflows due to underlying de-leveraging in the financial sector, especially with weaker emerging-market confidence.  In this context, the dollar should be able to maintain a firm tone in the short-term.    

The dollar dipped lower at the start of trading in 2012, but it quickly found fresh buying support and secured a strong advance against the Euro to beyond 1.28, although it lagged behind against the other major currencies.
 
The US ISM manufacturing data was stronger than expected with an increase to a six-month high of 53.9 for December from 52.7 previously which maintained the sense of cautious optimism towards the US outlook, especially as the orders component was strong.  The FOMC minutes from December’s meeting were broadly in line with expectations. The Fed did indicate that its internal Fed Funds forecasts would in future be released with the minutes and there was some speculation that this would lead to interest rates being left at ultra-low levels for even longer.

The ADP employment data was significantly stronger than expected with a reported increase of 325,000 for December from a revised 204,000 the previous month while jobless clams also fell. Although the correlation between the two is inconsistent, there was increased optimism surrounding Friday’s monthly payroll data.

Although there was some disappointment surrounding the ISM services-sector index with a reading of 52.6 from 52.0 previously, underlying optimism remained intact.  In this context, there was evidence of a significant divergence as the dollar tended to gain support from stronger than expected data, in contrast to much of the second half of 2011 when the US currency lost ground as risk appetite improved.

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Confidence in the Euro-zone will remain extremely fragile. There will be further concerns over the sovereign-debt situation given the risk that funding costs will continue to increase. The banking sector will remain a key focus as unrealised losses on bonds continue to undermine balance sheets and force additional capital raising.  There will be further concerns surrounding the Greek situation with open recognition that failure to secure a second bailout would trigger a Euro exit.  Even if the Euro area can be sustained intact, there will be very strong pressure for an even more expansionary ECB policy to ease the threat of a deep recession. In this context, the currency is liable to remain on the defensive.

The Euro initially attempted to gain ground with a record high number of speculative positions encouraging some short covering. The currency was unable to sustain the gains and weakened sharply for the weak as a while as it dipped to 16-month lows against the dollar and 11-year lows against the yen.
 
Markets remained uneasy over the very heavy timetable of debt issuance over the next few weeks which will test investor confidence in the region. The latest French bond auction recorded a small increase in yields compared with the previous sale in December and bidder interest was generally lacklustre. Although by no means a disaster, the auction reinforced an underlying lack of confidence.

There were further concerns over the Spanish economy with speculation that the country would need to draw on IMF support, especially with regional debt fears. There was a significant widening of Spanish yield spreads during the day which undermined Euro confidence. There was a warning from Greek officials that they would have to leave the Euro area if a second rescue package failed.

There were further concern surrounding the Euro-zone banking sector with a further sharp decline in Unicredit’s share price as well as rumours of capital raising by Deutsche Bank.  There were concerns surrounding provisions in the rights issue to guard against the possibility of  Euro break-up and this further unsettled market confidence. There were also further fears surrounding a contagion threat from Hungary as fears over the economy increased sharply.

As far as data releases were concerned, there was a small upward revision to the PMI services-sector data while the flash consumer headline rate declined to 2.8% for December from 3.0%. There will be further pressure on the ECB to take a more aggressive stance on monetary policy and there will also be continuing criticism of what the market sees as covert quantitative easing.

Yen:

There will be fears over a fresh economic downturn in 2012, especially if regional demand weakens further.  On fundamental ground there will be major fears surrounding the debt outlook, especially as the debt/GDP ratio remains extremely high. International considerations will also continue to play a pivotal role and there will be persistent fears of capital repatriation surrounding the Euro-zone. Underlying capital flows will therefore continue to underpin the yen in the short-term and the currency should be able to maintain a firm tone in the short-term despite weak fundamentals.

After initial vulnerability, the dollar found support in the 76.70 area against the yen and pushed significantly higher during the day. The Euro proved slightly more resilient against the yen that the dollar and technically this did have an impact in pushing the US currency higher.

The US growth indicators were also significant and the dollar did finally manage to gain some support on yield grounds as expectations of US out-performance were sustained. The employment data had a particularly important impact. There were further serious concerns surrounding the Euro-zone outlook and this had an important impact in curbing any yen selling pressure as capital repatriation was still a threat.

From a medium-term perspective, there is still a high degree of unease surrounding the fundamentals as Japan’s debt burden continues to increase. For now, these fears can still have a positive yen influence as institutions are more likely to repatriate funds to boost domestic reserve ratios.

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There will be further concerns surrounding the UK economy. The most recent business surveys have shown some important relief, but there is a high risk that the data has been distorted by weather-related factors and there will still be the threat of a sharp downturn over the next few months.  There is also the potential for further Bank of England quantitative easing which would reinforce medium-term Sterling fears.  In the short-term, there is still the potential for defensive capital flows into UK bonds, especially if Euro-zone fears increase further, although there will be the risk that these flows suddenly reverse.  Sterling will also be vulnerable if there is any downgrading of the AAA credit rating.

Sterling weaker against the dollar over the week, although losses were limited.  The UK currency continued to advance against the Euro and strengthened to 16-month highs beyond 0.83 which equates to a Sterling/Euro level above 1.20.
 
The latest PMI manufacturing index was stronger than expected with a recovery to 49.6 for December from a revised 47.7 previously.  The services-sector index was also stronger than expected with a reading of 54.0 for December from 52.1 previously and all three PMI readings were stronger than expected. Although there was caution surrounding the outlook, the data triggered some reassessment of the immediate UK recession risks and this was also important in supporting Sterling.

There was a further decline in money supply for the month and the very weak rate of monetary expansion will maintain fears over the 2012 economic outlook as well as maintaining pressure for the Bank of England to engage in further quantitative easing.  

The Bank of England warned that credit conditions were liable to tighten further and there will also be further concerns surrounding the consumer spending outlook.

There was a strong increase in overseas holdings of UK bonds which matches the evidence of substantial buying as a defensive play against Euro-zone turbulence.

Swiss franc:

Although the latest PMI data provided some relief, there will be further concerns over potential recession in the Swiss economy. There will also be deflation fears  and this combination will maintain National Bank determination to resist any renewed franc appreciation. There is the possibility that the minimum Euro level will be raised, although the bank may prefer to maintain stability and look for underlying capital flows to push the currency weaker.  There will be the risk that further fears surrounding the Euro-zone will actually trigger fresh defensive capital inflows which would create big stresses for the central bank.

The dollar found support on dips towards the 0.93 area against the franc during the week an advanced to highs around 0.9550, the highest for 10 months. The Euro found support close to 1.2150 amid reports of heavy central bank Euro bids in that region.

The latest Swiss PMI index was stronger than expected with a recovery to 50.7 for December from 44.8 previously.  Although the series is inevitably volatile, especially around the year-end period, there will be some relief over a recovery.  The National Bank will continue to monitor the situation closely, but immediate pressure for a raising of the minimum Euro level should ease slightly.

National Bank President Hildebrand insisted that he would not resignation over alleged currency trading by his wife.  The immediate currency impact was limited despite some speculation that the President’s longer-term position was compromised.

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The Australian dollar rallied in the first few trading sessions of 2012 and pushed to highs near 1.04 before weakening back to the 1.0250 area.  International risk considerations remained extremely important and initial enthusiasm surrounding 2012 tended to fade as Euro-zone fears increased.  There were also fears that initial relief surrounding the Chinese economy could reverse very quickly, particularly with the equity market under sustained selling pressure.

The domestic PMI indicators showed some signs of improvement, although international considerations tended to dominate.  There were also concerns surrounding the domestic housing sector.

The Australian dollar will continue to be subjected to high volatility and, rallies will continue to attract significant selling pressure given regional growth doubts.

Canadian dollar:

The Canadian dollar maintained a firmer tone early in 2012 and pushed to highs just beyond the 1.01 level before weakening back to the 1.02 area.

The currency gained underlying support from firm commodity prices as oil prices were underpinned by tensions with Iran. There were no major domestic developments, although there were some concerns surrounding rising consumer debt levels.

Although the Canadian dollar will find it difficult to gain ground given fears over the global outlook, the currency should prove to be broadly resilient.

Indian rupee:

The rupee has continued to find support beyond the 53 level against the US dollar, although rallies have remained generally limited.  After gaining some support from an improvement in risk appetite at the beginning of 2012, markets were generally back on the defensive as fears surrounding the Euro-zone increased again.

The Reserve Bank continued to express concerns surrounding a weak currency which suggested the potential for intervention. There was also some degree of optimism surrounding inflation as food prices fell slightly and any easing of policy would trigger inward investment flows.

Even if there is some further stabilisation, it will be difficult to secure more than a limited short-term rupee recovery given the underlying risk profile.

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The Hong Kong dollar has maintained a stronger tone over the past week with gains beyond the 7.77 level against the US currency.

There was evidence of arbitrage activity with funds looking to borrow dollars to buy the Chinese yuan, although this support may be only temporary if Chinese economic fears increase. There was still an important element of caution surrounding risk appetite which will curb capital inflows.

Risk conditions will remain very important Hong Kong dollar trends in the short-term and unease over the Chinese outlook will limit any significant gains.

Chinese yuan:

The PBOC continued to set a series of very strong fixings late in 2011 and pushed the currency to a record high just beyond 6.30 against the dollar before backing off in the first week of 2012. There was speculation that the gains were politically driven and that the bank did not further gains this quarter.

Although the PMI data provided some relief over the immediate economic trends, there were further important reservations surrounding the outlook, especially with continuing fears surrounding the property sector.