Weekly Forex Currency Review 08-02-2008

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Overall strategy: Confidence in all the major economies and currencies is likely to remain very fragile in the stort-term. This will create major uncertainty as investors weigh relative prospects and volatile trading conditions will be a high risk. Despite the increased recession fears, the dollar will continue to secure some protection on defensive grounds with reduced confidence in the Euro. Carry trades are unlikely to make much headway in the stort-term as credit-related fears are liable to intensify.                     

Key events for the forthcoming week

Dollar:

The very weak US PMI data will reinforce US recession fears in the stort-term and there will be speculation that the Federal Reserve will have to cut interest rates further to provide additional support to the economy. The US currency will, therefore, be very vulnerable on yield grounds. The dollar will secure some defensive safe-haven demand given the increase in risk aversion with potential capital repatriation. Increased fears over global economic trends will also provide support to the dollar with hopes that the US economy will be able to recover later in 2008.  Strong dollar gains remain unlikely.   
      
The dollar again proved to be resilient over the week and, after surviving the weak payroll data last week, the US currency gained significant strength over the second half of the week. The dollar pushed to highs beyond the 1.45 level against the Euro.

The US currency secured support as investors looking to increase weightings in defensive assets such as US Treasuries as global growth fears increased.

At the end of last week, there was a reported drop in US non-farm payrolls of 17,000 for January as manufacturing employment continued to fall and there was a sharp slowdown in services-sector growth. Unemployment fell to 4.9% from 5.0%.

The PMI index for the services sector fell very sharply to 41.9 in January from 54.4. This was the lowest reading since 2001 and is at a level which suggested wider recession conditions in the economy.

Factory orders rose 2.3% over the month following the robust durable goods report previously. Jobless claims fell to 356,000 in the latest week from 378,000 previously, although the number of continuing claims was at a 30-month high.

There was a smaller than expected increase in labour costs for the fourth quarter, although the impact was limited with markets focussed on growth prospects.

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There will be further concerns over the near-term economic trends, especially with evidence that the services sector is slowing sharply. The ECB will look to hold firm on inflation, but the bank has shifted to a neutral policy. There will also be further market speculation that the ECB will shift more decisively to cut interest rates during the second quarter which will tend to undermine the Euro. A tough ECB stance will not support the currency if there is evidence of serious economic deterioration.          

The Euro had a weaker tone over the week with sharp losses against the dollar. The currency was also weaker against most major currencies even though confidence in other economies was weak.

The ECB left interest rates on hold at 4.00% following the latest council meeting. Following the meeting, ECB President Trichet noted that there had been no calls for an interest rate increase or a cut at the meeting. This was an effective policy shift to a neutral stance as Trichet stated at the previous meeting that there had been calls for an increase in rates. Markets moved to price in a rate cut within the next few months.

There was a sharp downward revision to the Euro-zone PMI index for the services sector with a decline to 50.6 from a provisional 52.0. The German, Italian and Spanish indicators were all below the 50.0 threshold which suggests a contraction of activity.

There was a third successive fall in Euro-zone retail sales with a 2.0% annual decline as confidence remained weaker. German factory orders fell in December, although there was still solid annual growth.

The German Finance Ministry stated that the burden of exchange rate adjustment should not fall just on the Euro and there was speculation over more aggressive calls for Asian currency gains at the forthcoming G7 meetings.

Yen:  

There will be further concerns over Japanese economic trends, especially as the US slowdown will undermine exports. Overall, the Bank of Japan is unlikely to change interest rate policy over the next few months. The Japanese yen will gain support from the elevated levels of risk aversion and there will also be the potential for capital repatriation, especially towards the end of the fiscal year. There is still scope for net yen gains, although substantial buying is unlikely from current levels unless global recession fears intensify.      
                    
The yen was again unable to sustain gains through the 106.0 level against the US dollar during the week and dipped to test levels beyond the 107.50 level in choppy trading on Thursday as the US currency rallied.

The Japanese currency gained support at times from equity market weakness, although market conditions were erratic.

There were further cautious Bank of Japan remarks over the economy during the week, although the market impact was limited with officials also expressing hope that any slowdown would be temporary.

Ministry of Finance officials attempted to play down the potential discussion of currency rates at the forthcoming G7 meetings.

The economic data was generally weak with core machinery orders falling 3.2% in December to give a 3.3% annual decline.

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Confidence in the UK economy will remain weak in the stort-term with further expectations of a sharp slowdown in growth. There will also be fears that a housing sector deterioration will threaten a recession. The Bank of England will look to take a cautious stance given the inflation fears, but there are likely to be further cuts in interest rates and evidence of serious weakness would increase pressure for a more aggressive stance. In relative terms, unease over the major economies will provide important Sterling protection, but net losses are likely.      
 
Sterling found support weaker than 0.75 against the Euro during the week and strengthened to 0.7435 as the Euro was subjected to renewed selling. The UK currency weakened to lows just below 1.94 against the dollar.

Following the latest Bank of England MPC meeting, there was a cut in interest rates of 0.25% to 5.25%, the second reduction in three months. In the statement with the decision, the bank stated that credit conditions had tightened and that there was evidence of a slowdown in consumer spending.

The MPC was also particularly concerned over the inflation pressures within the economy with some fears that energy and food costs could push the headline inflation rate sharply higher.

The UK PMI index for the services sector was little changed at 52.5 in the latest month, although business confidence was slightly weaker.

The industrial-sector data was weaker than expected with production falling 0.1% in December while manufacturing output fell 0.2% over the month. There was a further deterioration in consumer confidence while the Halifax Bank stated that house prices were unchanged in January.
 
Swiss franc:

There are likely to be greater doubts over the Swiss economy following a series of weaker than expected data releases. There will also be some speculation over a cut in interest rates, although the SNB is more likely to hold steady in the stort-term, especially after the inflation data. The Swiss currency will continue to gain support from defensive inflows as risk aversion remains at elevated levels. If credit conditions deteriorate further, there will be some risk of rapid franc gains. 
 
The Swiss franc traded in a 1.0950-1.11 range against the dollar during the week with a weaker bias. After a retreat to 1.62 against the Euro, the franc strengthened back to beyond 1.60 later in the week as the Euro stumbled.

The Swiss currency continued to gain some support from elevated risk aversion levels as global credit fears persisted, although market conditions were volatile and fears eased slightly late in the week.

The seasonally-adjusted unemployment rate held steady at 2.6% in January. Consumer prices fell 0.3% in January with the annual inflation rate rising to 2.4%.

National Bank member Hildebrand warned that there were downside risks to the economy from the retail and export sectors which raised some speculation that the central bank would be forced to cut interest rates.

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The Australian dollar pushed to highs near 0.91 against the dollar early in the week, but was unable to sustain the gains and weakened back towards the 0.89 level. The currency gained ground on the crosses as yield support strengthened.

The Reserve Bank of Australia increased interest rates to 7.00% from 6.75% following the latest council meeting with the bank citing inflation concerns for the increase. The central bank forecast that there would be a slowdown in the economy during 2008 while giving no clear hints on future policy.

There was a 0.5% increase in retail sales for December while there was a sharp drop in building approvals.

Despite the improved yield support, the potential for Australian dollar gains will be severely limited by growing unease over the global economic trends.

Canadian dollar:

The Canadian dollar traded either side of parity during the week with a weakening bias and lows near 1.0120 against the US currency before a tentative recovery.

The PMI index recovered strongly to 56.3 in January from a reading below the 50.0 level the previous month. The improvement eased immediate fears over recession conditions in the economy, although caution prevailed.

The currency was unsettled to some extent by the drop in oil prices and weakness in commodity prices as unease over the global economy increased.

The Canadian dollar is unlikely to make significant headway in the stort-term given fears over the domestic and international growth trends with a slightly weaker trend.

Indian rupee:

The rupee has had a weaker tone, although movements have still been relatively contained with the local currency close to 39.57 against the US currency on Friday.

The rupee was unsettled by the downward trend in the local stock market with notable market declines over the second half of the week. The domestic currency was also unsettled slightly by fears over a slowdown in the Indian economy while emerging-market sentiment was more fragile.

The rupee drew support from the improved yield differentials, especially with speculation that US rates could be cut again.

Fears over the global economy and a more cautious investment stance will continue to expose the rupee to selling pressure, although heavy losses should be avoided.

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The Hong Kong has continued to find support in the 7.80 region against the US currency during the week. US dollar demand eased significantly when the currency approached the 7.80 level which cushioned the local currency.

Activity was dampened to a considerable extent by the lunar holiday. Stock market volatility triggered some fluctuations in the Hong Kong currency.

The Hong Kong currency should secure further support weaker than the 7.80 level against the US dollar.

Chinese yuan:

The yuan has been little changed against the dollar over the week despite briefly securing a post-float high for the tenth time during 2008. The Chinese yuan gained ground against the Euro during the week.

Activity was restricted by the New Year holidays during the week with many regional markets closed and the yuan settled around 7.1900 against the dollar.

There were continuing expectations that the authorities would sanction a faster rate of currency appreciation to contain inflation pressures. There was also speculation that a stronger currency would limit the need for a further interest in interest rates.

The yuan is likely to remain firm, especially as the central bank appears content to let the currency advance at a faster pace in order to help curb inflationary pressure. Fears over a sharp slowdown in the economy will curb buying support and could trigger at least a temporary reversal against the dollar.

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