Weekly Forex Currency Review 07-12-2007

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Overall strategy: Central bank policies will remain a key short-term focus. Markets will continue to speculate over the global impact of persistent credit stresses with the Fed interest rate decision due next week. Despite the current recovery in global stocks, underlying risk tolerances are likely to remain at lower levels. The US dollar will struggle to make strong headway in the short-term with higher volatility liable to persist.                    

Key events for the forthcoming week

Dollar:

There will be further concerns over the US economy with particular fears surrounding consumer spending trends and the labour market. The most recent releases have offered some encouragement and there is also greater confidence that the Federal Reserve action will help avert a recession which will curb dollar selling. In this context, the increased doubts over the global economy will also provide some protection to the US dollar. The fundamental doubts will limit the scope for gains by the US currency and sentiment could reverse rapidly.    
      
The dollar was subjected to choppy trading during the week with a pattern of sharp rallies quickly attracting fresh selling pressure. The US currency still secured net gains against the Euro, settling near 1.4610 on Friday, and also pushed to one-month highs on a trade-weighted basis.

The ADP employment report was stronger than expected with an increase of 189,000 in November after an upwardly-revised 119,000 increase the previous month which offered some optimism over the labour market, although jobless claims remained above the 330,000 level in the latest week

The ISM manufacturing index edged lower to 50.8 in November from 50.9 previously while the services-sector index fell to 54.1 from 55.8. The employment indicators were subdued in the reports while there was a jump in the prices components.

US Treasury Secretary Paulson continued to push ahead with plans to freeze the level of interest payments on certain sub-prime mortgages and lessen the risk of a surge in foreclosures, although housing sentiment remained at very weak levels.

There were fewer comments on the economy from Fed officials during the week. Markets continued to price in a further cut in interest rates next week, but speculation over a more aggressive 0.50% cut faded slightly.

Despite evidence of tensions, the Gulf Cooperation Council (GCC) stated that there would be no change to the dollar pegs which provided some US currency relief.

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The ECB concerns over inflation will persist in the short-term and the central bank will maintain a firm policy stance to prevent a further increase in inflation expectations. There will, however, also be increased doubts over the growth trends which will complicate the monetary policy requirements, especially with credit conditions remaining very tight. The currency should retain a firm tone on the ECB stance while remaining vulnerable to corrective retreats.    

The Euro was subjected to further corrective pressures during the week, but secured renewed gains following the ECB policy meeting. The currency recorded net gains against the yen and Sterling.

The ECB left interest rates unchanged at 4.0% following the latest council meeting.
Bank President Trichet stated that the bank would act in a firm and timely manner. The bank also warned over upside inflation risks while there were downside growth risks, illustrating the difficulties faced by the ECB.

The bank's stance overall was slightly stronger than expected with Trichet pointedly stating that there had been some calls for rates to be increased at the meeting which severely dampened any market speculation that rates could be cut in the near term.

The economic data was mixed with data the industrial sector was holding firm while there were weak readings for retail sales as consumer demand faltered. Producer prices rose 3.3% in the year to November, illustrating the unease over inflation trends.

German Finance Minister Steinbruck stated that currency moves had become disorderly, but the ECB steered away from making aggressive comments over Euro trends at the policy meeting.

Yen:  

The domestic economic trends should remain of secondary importance in the short-term, although the yen will be unsettled to some extent if there is evidence that growth conditions are deteriorating. The Japanese currency will come under pressure if risk appetite continues to strengthen. There is still likely to be underlying demand for defensive currencies given that credit conditions will  remain tight over the year-end period. Overall, the Japanese currency should be able to avoid heavy losses with shorter-term consolidation realistic.                      
                    
The Japanese yen was unable to sustain gains stronger than the 110.0 level against the dollar during the week and drifted lower towards 111.50 on Friday despite the weight of additional exporter selling.

The Japanese currency continued to fluctuate in line with movements in global stock markets and risk aversion levels. In this context, a more robust Wall Street trend helped push the currency weaker as risk appetite strengthened.

The latest capital account data recorded strong net inflows for the latest reporting week with some evidence of capital repatriation.

Bank of Japan Governor Fukui stated that the bank would act at the appropriate time, but did not signal a near-term increase in interest rates. GDP growth was revised lower to 0.4% for the third quarter which curbed sentiment towards the economy.

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There will be further unease over the UK economic trends, especially after a run of particularly poor data surrounding the housing sector. Following this week's Bank of England interest rate cut, there will be pressure for further reductions over the next few months which will tend to undermine Sterling support. The UK currency will gain some protection from unease over Euro-zone growth trends, but the net risks still point to depreciation for the currency. 
 
Sterling weakened sharply against the dollar for the week as a whole with lows below the 2.02 level before a tentative recovery. The UK currency also weakened to re-test 2003 lows against the Euro beyond the 0.7220 level

The Bank of England cut interest rates by 0.25% in December to 5.50%, the first reduction for two years. The bank pointed to the downside economic risks emanating from the credit restrictions, but there were still some concerns over inflation within the statement. Market rates remained at elevated levels as credit stresses persisted.

The UK economic data was generally weak with the PMI index for the services sector weakening to a four-year low of 51.9 from 53.1 the previous month. The construction PMI index also dipped to a 14-month low.

The British retail consortium reported a 1.2% annual like-for-like increase in sales while consumer confidence weakened sharply. The Halifax Bank reported that house prices fell 1.1% in November, the third successive monthly decline, while evidence of credit tightening persisted as confidence in the property sector faltered.

Swiss franc:

The Swiss economic data has generally remained firm with evidence of solid demand. The National Bank is likely to retain a tightening bias for policy even if it decides to leave interest rates on hold at the December meeting. The Swiss franc trends will also be correlated strongly with levels of risk aversion and a sustained easing of credit fears would curb currency demand. Nevertheless, the franc should be able to avid heavy selling pressure given the underlying stresses.          
 
The Swiss currency weakened to lows around 1.1350 against the US dollar during the week and also weakened to test levels beyond 1.65 against the Euro.

The Swiss franc continued to fluctuate in line with moves in global stock markets with a firmer Wall Street trend lessening near-term demand for the currency.

The local currency drew some support from an OECD suggestion that interest rates should be increased again to combat inflation pressure.

This support was offset by National Bank intervention to add liquidity to bring money-market rates down. The seasonally-adjusted unemployment rate held steady at 2.6% for November.

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Although the Australian dollar had a slightly weaker tone over the week, it found support close to the 0.8650 level against the US currency before regaining some ground late in the week with a move back above 0.8750.

The Reserve Bank of Australia left interest rates on hold at 6.75% following its latest policy meeting. The bank also expressed some doubts over 2008 growth trends and markets were less confident that interest rates would be increased again next year.

Third-quarter GDP growth was 1.0% as demand remained solid to give a 4.3% annual increase. The trade deficit rose sharply to a record AUD2.98bn for October from AUD1.70bn previously as exports dipped sharply over the month.

The Australian dollar will look to gain support on yield grounds, especially when risk tolerances improve. Domestic and international growth doubts will restrict the potential for currency gains with volatility a persistent risk.

Canadian dollar:

The Canadian dollar drifted weaker ahead of the Bank of Canada's interest rate decision. The currency weakened to lows beyond 1.02, the lowest level since the second half of September before consolidating around 1.01.

Following the Bank of Canada monetary meeting, interest rates were cut by 0.25% to 4.25% due to expectations of weaker growth. The bank stated that forthcoming data releases would be monitored closely in determining future decisions.

The PMI index strengthened to 58.7 in November from 57.1 the previous month which alleviated immediate fears over a sharp downturn in the economy. There was also a sharp recovery in building permits for October.

Bank of Governor elect Carney rejected the possibility of a peg with the US dollar. The central bank expressed relief that the Canadian dollar had retreated back towards the central bank's assumed trading range for the currency.

Expectations of a growth slowdown and further interest rate cuts will curb Canadian currency demand. It should be able to resist heavy selling from current levels.

Indian rupee:

The rupee was confined to relatively narrow ranges over the week with contradictory pressures. There was a slight strengthening trend as risk aversion eased and the currency edged slightly stronger to 39.46 against the dollar on Friday.

The rupee gained support from strength in global stock markets which encouraged a renewed inflow of funds into Indian markets after outflows during November.

This support was offset by general US dollar resilience over the week which curbed short-term selling pressure on the US currency.

The rupee will gain some further support if risk aversion eases on a sustained basis. The currency is still unlikely to secure more than limited headway in the short-term.    

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The Hong Kong dollar had a generally weaker tone and dipped to near the central rate of 7.80 against the dollar during Thursday before a slight recovery on Friday.

The local currency was undermined by a generally firmer US dollar tone during the week while there was increased corporate demand for the US currency.

Lower local interest rates also was contributed to a weaker tone due in part to a release of funds after recent IPO offerings. Underlying capital flows into the stock market provided underlying support to the Hong Kong dollar.

The Hong Kong dollar should be able to find near-term support close to 7.80 against the US dollar unless the Federal Reserve decides against a further cut in interest rates.

Chinese yuan:

The Chinese yuan weakened sharply on Thursday with a drop to around 7.410 against the dollar from 7.388 before regaining ground on Friday. The yuan was restrained by a generally stronger US currency tone over the week, but retained a firm underlying tone as losses quickly attracting fresh support.

The yuan still gained support from expectations that further monetary tightening would be required to stem inflationary pressure. The central bank stated that there will be a shift to a tight monetary policy, reinforcing expectations of higher rates.

There was also speculation that the Chinese authorities would allow greater daily fluctuations for the Chinese currency which helped underpin the yuan.

There was also speculation that the yuan would be allowed to push stronger next week with Sino-US trade talks due to take place between Tuesday and Thursday.

The underlying trend is still likely to be for further yuan appreciation given the monetary pressures. A wider daily fluctuation band or one-off revaluation remains a realistic policy option if inflation pressures fail to ease.