Weekly Forex Currency Review 06-07-2007

Overall strategy

Unless there is a weak monthly employment report on Friday, the US dollar should be able to secure increased yield support which will help cushion the currency from further losses and there is the potential for fragile gains. An overall credit tightening is likely to trigger increased demand for defensive currencies over the next few weeks with greater market caution over carry trades during July and August.

Key events for the forthcoming week

The US ISM surveys have remained strong for this month and confidence in the economy is liable to strengthen further if there is a firm employment report. Market expectations that interest rates will decline are liable to fade and this should underpin the dollar, especially as bond yields have increased again. High oil prices will maintain inflation fears, but will probably not be a net positive for the dollar. The US currency will still be hampered by fears over mortgage-related difficulties while rallies will be stifled by structural selling.

The dollar was subjected to downward pressure at the end of last week. As confidence deteriorated, the trend continued this week with the US currency weakening to lows beyond 1.3650 against the Euro before a tentative recovery to 1.3580.

The US ISM index for the manufacturing sector increased again to 56.0 for June from 55.0 the previous month with orders and production indices remaining firm.

The services sector index was also robust with an increase to 60.7 in June, the highest level since April 2006.

US 10-year yields fell to the 5.00% level before a recovery back to 5.15% on Friday as expectations over a cut in interest rates faded again after the stronger than expected data.

The ADP employment report recorded an increase of 150,000 for June which increased optimism over a solid payroll report. There were still concerns surrounding the housing sector as pending home sales weakened

Euro

The ECB will maintain a tightening bias on interest rates and will expect to increase interest rates again in September. The euro-zone data has also remained generally firm, but there is the risk of a deterioration over the next few weeks, especially in the consumer and property sectors. The Euro has also priced in further interest rate increases to at least 4.5% by the end of 2007 which will make it difficult to extend gains.

The Euro held firm over the week, but was subjected to some profit taking following Thursday's ECB policy decision given that the currency had been bid higher ahead of the meeting.

The ECB left interest rates on hold at 4.00% following the latest council meeting. In the press conference following the decision, President Trichet stated that the bank would closely monitor inflationary pressure. The comments suggested that the bank will look to increase interest rates in September or October at the latest, especially with Trichet stating that he was not looking to alter market expectations.

The Euro-zone PMI indices remained strong for June in the services sector despite significant variations from individual countries.

The retail sales data was weaker than expected with a 0.5% monthly decline for May which cut annual growth to 0.4%.

There was evidence of some stresses between the ECB and French President over the issue of exchange rate management with the ECB rejecting calls for a more interventionist policy.

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The Bank of Japan looks set to increase interest rates in August while the Japanese authorities will also take a firmer stance in deterring further aggressive yen selling. The Japanese currency will still be undermined by interest rate considerations and retail outflows as yield plays remain dominant. Selling will tend to increase if global volatilities remain low. The Japanese currency will need a sustained reversal in risk tolerances to secure strong reversal. The net credit risks suggest at least a partial yen recovery.

The yen was unable to sustain any significant rallies during the week and hit resistance close to 122.0 against the dollar while it weakened to fresh record lows against the Euro.

There were no significant Japanese data releases during the week with global yield trends still the dominant influence.

There was some caution over aggressive yen selling as Shinohara was confirmed as the new top Japanese international finance official which prompted speculation over increased opposition to yen weakness.

The yen also gained marginal support from a potential ratings upgrade by Moody's

Sterling

The UK currency will look to secure further short-term support from yield considerations, especially with markets looking for a further increase in interest rates within the next few months. The UK currency has priced in a lot of favourable news and there is the threat of a sharp slowdown in consumer spending during the current quarter. In this context, there is the threat of a downgrading in interest rate expectations which is liable to trigger a sharp correction weaker in Sterling.

Sterling pushed to fresh 26-year highs around 2.02 against the dollar during the week. Subsequently, there was a retreat back to 2.01 as the UK currency drifted weaker against the Euro.

The Bank of England increased interest rates to 5.75% from 5.50% following the latest MPC meeting with rates at the highest level for six years.

In the statement following the decision, the bank stated that the medium-term inflation risks were still to the upside even though the headline inflation rate should move back to the 2.0% level this year. The MPC judged that there was little spare capacity in the economy while money supply and credit growth remained elevated.

The CIPS survey evidence remained firm with an increase in the services index, although there was a small monthly decline in the manufacturing index.

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The latest inflation data was slightly lower than expected which should calm immediate National Bank fears over inflation. The bank, however is still likely to be uneasy over underlying trends and is likely to remain opposed to renewed franc weakness. The Swiss currency remains vulnerable as a funding currency, but the franc will gain if there is a sustained increase in risk aversion. The overall risk profile suggests that the franc will strengthen during the third quarter.

The Swiss currency was unable to sustain gains beyond the 1.65 level against the Euro and the franc also hit tough resistance close to 1.21 against the dollar with two failed attempts to push through this level followed by a move to 1.2190..

Swiss consumer prices rose 0.1% in June with the annual inflation rate rising to 0.6% from 0.5% the previous month, although this was a smaller increase than expected. The headline unemployment rate fell to 2.5% in June from 2.6%, a 5-year low.

Resilient global stock markets helped lessen short-term franc demand during the week

The franc also secured only brief support from terrorism alerts in the UK.

Australian dollar

After the sharp retreat last week, the Australian dollar quickly recovered ground and pushed to a fresh 18-year high at close to 0.86 against the US dollar before a limited retreat.

The Australian Reserve Bank left interest rates at 6.25% following the latest council meeting.

The retail sales data was weaker than expected with a 0.1% decline for May while the revised data also recorded a monthly decline for April. The trade deficit narrowed to AUD0.81bn from a revised 0.92bn the previous month.

The Australian dollar gained some support from rising metals prices during the week while yield considerations remained generally dominant in the markets.

The Australian currency will benefit from high yield spreads, although there is still the risk of a sharp correction weaker

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The Canadian dollar was able to resist significant losses against the US currency during the week, but hit resistance close to 1.0540.

The Canadian currency continued to draw support from high oil prices with levels consistently above US$70 p/b.

There was a strong recovery in building permits from the month, although there was some general caution ahead of the key employment data.

The Canadian dollar should gain further support from expectations of an interest rate increase next week unless there is a very weak employment report on Friday.

Indian rupee

The India rupee advanced during the week and strengthened to fresh nine-year highs beyond the 40.50 level during the week. The rupee settled close to 40.50 on Friday with evidence that the central bank was again intervening to curb gains.

The Indian currency continued to draw support from continued strength in the local stock market and capital inflows. Institutional fund inflows have amounted to US$5.8bn so far this year after inflows of US$8.0bn during the whole of 2006.

High oil prices acted to undermine the rupee slightly during the week with crude prices trading above the US$70p/b level.

The wider weakness in the US dollar also underpinned the Indian currency during much of the week.

The rupee will remain strong while global risk tolerances remain high, but there are still high risks of a significant correction weaker while the Reserve Bank will block strong gains.

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The Hong Kong dollar strengthened to highs around 7.8115 against the US currency during the week, but was unable to sustain the gains and weakened back to 7.8170 on Friday.

There was strong demand for the Hong Kong dollar ahead of the Fosun International IPO offering which supported the local currency, especially as the issue was oversubscribed. Demand then fell back once the issue closed and this weakened the Hong Kong dollar.

The increase in US bond yields helped trigger renewed arbitrage activity late in the week which undermined the local currency.

The Hong Kong dollar will remain strongly influenced by arbitrage activity with resistance realistic close to 7.8130 against the US currency unless US yields fall sharply.

Chinese yuan

The Chinese yuan pushed through the 7.60 level against the dollar, a fresh high for the Chinese currency since the 2005 controlled float. The was a partial reversal of the gains late in the week with a move back towards 7.6130.

The Chinese yuan gained from a weaker US currency, but there was some retracement later in the week as the central bank guided the mid point slightly weaker while the US dollar recovered slightly.

Robust Asian stock markets helped support the yuan during the week and there were expectations of a record June Chinese trade surplus which supported the Yuan.

The underlying fundamental pressure for a stronger Chinese yuan will continue with gradual appreciation the most likely outcome.