Weekly Forex Currency Review 07-09-2007

Overall strategy

The dollar will continue to be damaged by fears over a hard landing for the US economy and the Federal Reserve will remain under pressure to lower borrowing costs. The sustained increase in risk aversion should provide important protection to the Japanese yen and Swiss franc and will also provide some dollar support, especially with the risk of further European banking-sector difficulties.     

Key events for the forthcoming week

Dollar

There will be further unease over US economic trends as the housing sector remains under pressure and a weak payroll report this Friday would reinforce recession fears. In this environment, there will be further pressure for a Federal Reserve cut in interest rates and, although the Fed will resist a major cut in rates, there is at least a 50% chance of a September cut. The dollar will secure some protection from the fact that a series of rate cuts are already priced in and risk aversion will also provide some support. Fears over reserve diversification will act as an important brake on dollar recoveries.  
      
The dollar was unable to sustain gains against European currencies and weakened to lows beyond 1.37 against the Euro. The US currency failed to secure gains when Wall Street dipped as increased fears over the economy offset potential defensive demand.

The US housing data remained weak with pending home sales falling 12.2% in August to the lowest level since 2001, while mortgage foreclosures also rose.

The ISM index for the manufacturing sector weakened to 52.9 in August from 53.8 the previous month while the services-sector report was unchanged at 55.8.

The employment evidence was mixed. The ADP report recorded an employment increase of only 38,000 for August which reinforced concern over the monthly employment report. Reported layoffs also increased, notably in the financial sector, while the ISM employment components were relatively weak. Jobless claims, however, fell to a four-week low of 318,000 in the latest week.

The Federal Reserve's Beige Book reported that the residential housing slump was deepening, but that retail sales and employment were growing.

Comments from Fed officials suggested that the central bank was cautiously edging towards a cut in interest rates, although the central bank was anxious to take an independent stance.

Credit-related stresses persisted with the money-market rates still significantly above the reference rates despite regular liquidity injections by the Fed.

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The ECB decision to keep interest rates on hold will restrain near-term Euro demand, especially as the bank omitted references to strong vigilance which will create major doubts over an October increase as well. There will also be further concerns over the Euro-zone economy with particular concerns surrounding Spain. Given that the ECB has not signalled that interest rates have peaked, heavy selling pressure on the Euro should be avoided unless there is evidence of further serious banking-sector difficulties.            

Despite advancing against the dollar, the Euro struggled to find direction against most other major currencies during the week with net losses against the yen.

After heavy hints by official sources that rates would not be changed, the ECB left interest rates at 4.00% following the latest council meeting.

In the statement following the decision, ECB President Trichet stated that the bank would time firm and timely action and emphasised inflation concerns. He avoided more aggressive rhetoric which would have indicated an October increase in rates while the bank's GDP forecasts were lowered slightly.

German factory orders fell sharply in July by 7.1%, although this followed strong gains this previous month and there was a robust annual increase. Euro-zone retail sales rose a limited 0.5% in the year to July.

Officials were generally cautious over the economic outlook with the Spanish Finance Minister notably cautious over the growth prospects.

Yen

Markets are not expecting the Bank of Japan to increase interest rates in the short-term which will limit yen support, although the evidence suggests that the bank will look for an opportunity to raise rates. Investors are likely to retain a more defensive stance in the short-term with reduced institutional outflows from Japan. There is also the risk of a further underlying reduction in carry trades as global leverage is scaled back. The Finance Ministry will discourage aggressive dollar selling and there will be institutional US currency buying on any significant US retreats. Nevertheless, there is scope for underlying yen gains.                
                    
Yen ranges against the dollar narrowed over the week, but the Japanese currency had a generally firmer trend with a challenge on levels below 115.0. The yen also found strong firm support close to 159 against the Euro.

Finance official Watanabe warned that the ministry was watching the sub-prime affair while he also stated that there was a risk that carry trades would be unwound which unsettled confidence in high-yield currencies.

There was little in the way of domestic data releases over the week. Markets cut the chances of a September interest rate increase to around 10%, primarily due to international market conditions.

Risk-reversal prices on yen options continued to indicate that there was strong interest in yen calls which helped support the currency as volatility remained relatively high.

A further tightening of Chinese monetary policy provided some support to the Japanese currency.

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The most recent economic data has still suggested that the economy is growing steadily.  The cautious Bank of England stance will, however, tend to limit Sterling buying support. There are also increasing risks surrounding the property sector and the tightening of credit conditions will act as a significant policy tightening independent of bank action. If these stresses do not ease, then there will be pressure for the Bank of England to cut interest rates to offset the economic impact and Sterling would then be vulnerable to a sharp decline.              
 
Sterling resisted a further test of support below the 2.00 level against the dollar and strengthened to test highs around 2.0250. The UK currency also held firm against the Euro before weakening after the interest rate decision.

The Bank of England left interest rates on hold at 5.75% following the latest monetary meeting. In a rate statement following a decision to leave rates on hold, the bank stated that there was limited spare capacity, but that earnings growth was subdued while there was tentative evidence of slower consumer spending. The central bank stated that it was too soon to assess the impact of credit-market tensions.

Money market rates remained tight with 3-month inter-bank rates at a 9-year high around 6.80% as liquidity remained tight.

The survey evidence was generally firm with the manufacturing PMI index rising to a 3-year high while the services-sector index also rose slightly over the month.

The industrial data for July, however, was disappointing with a 0.1% production decline for the month. The latest BRC survey evidence also suggested an underlying slowdown in consumer spending.

Swiss franc

The Swiss fundamentals should remain firm with solid growth set to continue. The National Bank will closely debate the September interest rate decision, but the steady ECB stance will help protect the franc if rates are not increased and there is at least a 50% chance that Swiss rates will be increased. The underlying caution over carry trades will also continue to protect the Swiss currency, especially if Euro-zone economic fears increase. In this environment, the franc should continue to find solid support on any retreats against major currencies.   
 
The franc found support close to 1.2150 against the dollar and regained ground to test the 1.20 level on Thursday. The currency edged stronger to 1.6430 against the Euro.

The Swiss PMI index remained strong with an increase to 65.1 for August which maintained confidence over the economy. The seasonally-adjusted unemployment rate held steady at 2.7% for the month.

There was uncertainty over the National Bank's September interest rate decision with no significant comments from bank officials.

The Swiss currency remained correlated strongly with movements in global stock markets as persistent credit fears maintained high levels of risk aversion.

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The Australian dollar found support below the 0.81 level against the US currency and pushed back towards the 0.83 level as the US dollar was subjected to wider selling.

The Australian Reserve Bank left interest rates unchanged at 6.50% following the latest council meeting.

The employment data was strong with a 31,900 increase in employment for August while unemployment was steady at 4.3%. The GDP data was also robust with a 0.9% increase for the second quarter.

The Australian dollar was still hampered by increased levels of risk aversion with caution over carry trades and regional investment flows.

The Australian currency will look to take advantage of US dollar vulnerability, but there will be limited scope for gains given the combination of high volatility and a sustained increase in risk aversion.

Canadian dollar

The Canadian dollar was contained in narrower ranges during the week and found further resistance close to the 1.05 level against the US dollar.

The Bank of Canada left interest rates unchanged at 4.50% following the latest monetary meeting. The central bank remained concerned over inflationary pressure, but was reluctant to commit itself to a further near-term interest rate increase.

There was a sharp drop in building permits for the month, but the PMI index recovered for August. Firm oil prices helped provide support to the currency.

Firm fundamentals will cushion the Canadian dollar, but it will be difficult to secure significant gains, especially as global interest in carry trades will remain lower.

Indian rupee

The rupee has secured a stronger tone over the week with further support beyond the 41.00 level against the dollar and the Indian currency strengthened to 40.70 on Friday.

There has been greater optimism over capital inflows which has helped support the currency as regional markets attempted to distance themselves from US market trends, although caution has still been a notable feature.

The trade deficit increased by over 25% in the year to July to US$5.01bn as import volumes rose strongly which raised some competitiveness concerns. The Indian currency was undermined to some extent by the high level of oil prices.

The rupee should prove resilient in the short-term with confidence over the economy, but the overall tightening of global credit conditions is still likely to lead to a gradual overall depreciation over the next few weeks

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The Hong Kong dollar has continued to secure a firmer tone with gains to beyond 7.79 against the US dollar and a move to 7.7865 on Friday was a 7-month high for the local currency as Hong Long selling eased.

Tight local money markets underpinned the Hong Kong dollar, especially with reduced confidence in the US currency which reduced arbitrage activity.

There was Hong Kong dollar demand associated with forthcoming IPOs. Regional currency strength also helped underpin the Hong Kong dollar over the week with the Chinese yuan also retaining firm tone.

The Hong Kong dollar will still find it difficult to strengthen significantly further against the US currency even with the potential for a firm near-term stance.

Chinese yuan

The Chinese currency has strengthened during the week with the central bank's reference rate moving to nearer the market rate as tensions between the markets and central bank eased. The yuan settled close to 7.54 against the US currency.

The central bank tightened monetary policy again with an increase in reserve requirements to 12.5%.

Speculation over a faster pace of Chinese yuan gains was reinforced by a meeting between President Hu and US President Bush

The net trend is still likely to be for a stronger Chinese yuan, especially with continuing pressure for a tighter monetary policy to curb domestic overheating.