Weekly Forex Currency Review 09-02-2007

Overall strategy:

There will be further interest in carry trades if G7 countries fail to reach agreement on stemming yen weakness, although substantial caution will still be required with volatility levels likely to remain higher. There is a risk of further stalemate between the Euro and dollar with the Euro likely to find difficulties in sustaining any gains beyond the 1.3050 level.    

Key events for the forthcoming week

Dollar:

The firm evidence over US services-sector growth will continue to offset concerns over the manufacturing sector and overall confidence in the economy should remain firm. Existing yield spreads will offer dollar protection, but the US currency is likely to require expectations of higher interest rates to secure firm buying interest. In this context, it will remain very difficult to break resistance levels below the 1.29 level against the Euro, especially as housing fears could re-surface in the short term.

There was little major US data over the week and this made it difficult for the dollar to capitalise on the firm employment report released at the end of the previous week.

The US ISM services index rose to 59.0 in January from 56.7 the previous month, maintaining optimism over the services sector, although the underlying components were less impressive. Jobless claims were little changed at 311,000 for the latest week. There were some concerns over the housing sector late in the week after an HSBC bad-debt warning.

The Federal Reserve retained a firm stance on interest rate with regional Governor Plosser stating that the risks for the economy and shifted to the upside while he also warned that interest rates might need to rise again. The comments failed to have an impact on interest rate expectations with 10-year bond yields edging down towards 4.72% from 4.80% last week.

The firm ECB statement and strong expectations of an interest rate increase in March will support the Euro in the short term. Further rate increases have, however, been priced in which will make it difficult for the Euro to secure firm buying interest.  Markets will also remain sensitive to evidence of a sharp slowdown outside Germany.

The Euro remained on the defensive against low yield currencies over the first half of the week, but was able to regain ground as pressure to close carry trades faded.

The ECB left interest rates unchanged at 3.50% following the latest council meeting. In the press conference following the decision, ECB Chairman Trichet stated that the bank would maintain strong vigilance over inflation and this was a strong hint that the central bank would raise interest rates at the March 8 meeting.

The Euro-zone economic data was mixed with the PMI index for the services sector strengthening to 57.9 in January from 57.2. The German industrial orders and production data were weaker than expected, although annual growth was still favourable. French and Italian industrial data was also strong for December.

Yen:  

The yen will remain vulnerable on yield grounds, especially as the comments from Bank of Japan officials have cast further doubts over a February interest rate increase. The G7 meetings will be an important short-term influence and the yen will be vulnerable to renewed selling if there is no agreement on the need to stem yen weakness. The investment flows have, however, continued to record net inflows and seasonal trends will become more supportive which will limit yen losses with volatility liable to remain high.
                    
The yen strengthened to 120.0 against the dollar during the week on a closing of short positions, but was unable to sustain the gains and weakened back towards 121.5 with the yen also suffering renewed losses against the Euro.

There were further protests against yen weakness from European officials ahead of the G7 meetings. These concerns were not shared by Japanese officials and US Treasury Secretary Paulson also failed to express any support for intervention.

Bank of Japan member Haru stated that there was no hurry to raise interest rates and that a weak yen had a beneficial impact on the economy which reinforced the yen’s negative yield structure. The latest capital account data, however, again recorded strong inflows which offered some yen protection.

Sterling:

The Bank of England decision not to increase interest rates again this month will undermine Sterling to some extent, although the impact should be measured given that markets are still expecting an increase within the next 2-3 months. Nevertheless, the more aggressive interest rate expectations are liable to be scaled back and the currency will be much more vulnerable if there is evidence of deterioration in the housing sector.

Sterling was subjected to volatile trading against the Euro with losses to one-month lows beyond 0.6670 after the Bank of England interest rate decision. The UK currency also failed to hold above 1.97 against the dollar.

The Bank of England left interest rates at 5.25% following the latest MPC meeting and there was no MPC statement. Ahead of the decision, there had been some speculation over back-to-back rate increases and the UK currency weakened after the decision with lows around 1.95 against the dollar on Friday.

The UK data suggested still firm retail spending during January, but the overall data tone was mixed with the ISM index for the services sector recording a slight deterioration for the month. Similarly, house prices rose in January with future indicators less robust.

Interest rate expectations will remain important in the short-term and the low consumer inflation figure will dampen expectations of a more aggressive National Bank monetary tightening. The franc will, therefore, remain vulnerable to selling pressure on yield grounds, although this pressure should be offset by confidence in the fundamentals. Overall, there is likely to be further franc support weaker than 1.2550 against the dollar.
  
The franc strengthened to 1.6075 against the Euro over the first half of the week on a reduction in short-positions, but the Swiss currency suffered renewed losses late in the week with depreciation back towards 1.6250.

National Bank member Hildebrand stated that more interest rate increases would be required if growth remained strong and the remarks provided initial franc support.

The Swiss consumer prices data was significantly weaker than expected with a headline 0.7% increase in prices for January which cut the annual inflation rate to 0.1%. The low inflation rate dampened expectations that the National Bank would accelerate interest rate increases over the next few months.

Australian dollar:

The Australian dollar found support near 0.77 against the US dollar and strengthened to highs around 0.7815 on Thursday, but was unable to sustain the gains. As expected, the Reserve Bank left interest rate at 6.25% following the latest monthly meeting.

The headline employment data was weaker than expected with a drop of 3,600 for January, but full-time employment was higher and there was a drop in unemployment.

Interest rate expectations did not shift significantly with the Australian currency drawing support from a renewed flow of funds into high-yield currencies out of the yen. Firm commodity prices also provided currency support

The Australian dollar may secure a firm tone in the short-term, but will struggle to make significant headway with higher volatility liable to be a feature.

The Canadian dollar was unable to gain any significant momentum against the US currency during the weak and dropped to lows around 1.1870 before a partial recovery to 1.1830.

There were concerns that the monthly employment data would be disappointing and the high level of oil prices failed to offer significant currency support during the week as sentiment towards the currency remained weak.

The domestic data was mixed with a stronger reading for the January PMI index and rising housing starts, but with weakness in building permits which increased market uncertainty.

Overall, the currency should be able to find short-term support close to current levels even with confidence remaining weak.

Indian rupee:

The Indian rupee strengthened to highs of 44.05 against the US dollar at the end of last week, but failed to secure further gains in the first half of this week. There was evidence of oil importers buying dollars which restrained the rupee.

There was further speculation over central bank intervention to curb currency gains, especially after data showed that there was dollar buying worth US$5.0bn during November and December. The Indian currency strengthened to 44.05 on Friday due to speculation that the Finance Ministry was promoting a firmer currency to restrain inflation and was uneasy over central bank intervention to cap currency gains.

Regional currency trends remained important with the rupee benefiting from yen strength when the yen strengthened to 120.0 against the dollar, but Japanese moves were a negative feature later in the week  Overall, there is the potential for the rupee to attack the 44.0 level, but resistance here will be tough to break.

Hong Kong dollar:

The Hong Kong dollar remained weaker than the 7.80 central rate and dipped to a fresh 17-year low of 7.8160 before a slight recovery to 7.8130 on Friday.

The Hong Kong currency was still undermined by persistent arbitrage activity due to the higher level of US interest rates, although this pressure on the local currency should ease if the spot rate weakens towards the 7.82 level.

The Hong Kong dollar was unsettled by yen weakness and the strengthening of the Chinese yuan through the 7.75 level failed to have a significant market impact. The Hong Kong dollar is liable to remain trapped weaker than 7.80 in the short term.