Weekly Forex Currency Review 09-03-2007

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Overall strategy

Market tensions have subsided following a rally in global equity markets and there will be a renewed temptation to channel funds into high-yield currencies. The overall credit tightening, however, suggests that underlying demand for defensive currencies will continue which should curb renewed yen losses. The dollar will need a stream of favourable data to dispel doubts over growth trends and speculation over lower interest rates.      

Key events for the forthcoming week

Dollar

There will be further short-term unease over US growth prospects. There will also be concerns that weakness in the sub-prime mortgage sector will spread to other areas of the economy. There has been evidence of rising wage pressures and the Fed will be very reluctant to sanction a cut in interest rates while inflation concerns persist. Given that markets have priced in an interest rate cut by August, the dollar should be able to avoid further sharp selling pressure with support close to 1.3250 against the Euro unless forthcoming data is very weak.  

Early in the week, the dollar strengthened to 1.3070 against the Euro as continuing global stock market declines triggered defensive demand for the currency. The dollar was unable to hold the gains and weakened to 1.32 before stabilising close to 1.3150.

The US economic data failed to offer significant support to the US currency, although much of the releases were of secondary importance. 

Factory orders, for example, fell by the largest amount for 6 years in January with a 5.6% monthly decline while pending home sales also fell over the month. The ISM index for the services sector fell to 54.3 in February from 59.0 in January, although the underling data suggested that the headline figure should have been stronger.

Although jobless claims fell, market concerns over the employment report increased and the markets priced in a 100% chance of a Federal Reserve interest rate cut by August. The inflation data caused some concerns with fourth-quarter unit labour costs revised sharply higher. There were no major Fed comments on interest rates.

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The comments from ECB officials suggest that the bank is expecting to tighten policy only once more before settling on an extended pause. This ECB stance will provide background Euro support, but is unlikely to trigger firm buying. European officials will continue to encourage gradual Euro depreciation against the yen, but the Euro should be able to resist heavy selling on the major crosses.

The Euro temporarily weakened sharply against the yen with position adjustment pushing it to lows below 150.0 before a strong recovery back to 154.0. The Euro also recovered significantly from the weakest levels near 1.5950 against the Swiss franc.

The ECB increased interest rates to 3.75% from 3.50% at the latest council meeting, in line with market expectations. In the press conference following the decision, ECB Chairman Trichet stated that the bank would monitor price risks very closely while longer-term inflation forecasts were raised slightly.

Trichet, however, also stated that interest rates were now at a moderate level, in contrast to recent meetings where rates have been described as low. This shift in emphasis fuelled expectations that the ECB would stop tightening at 4.0% at most.

The Euro-zone data was mixed with German industrial production rising 1.9% in January while there was a drop in factory orders for the second successive month. The Euro-zone services PMI index weakened slightly to 57.5 in February from 57.9.

Yen 

The underlying capital flows will continue to be more yen supportive over the next two weeks with capital repatriation ahead of the fiscal year-end. Global risk aversion levels have eased which will encourage renewed short-term yen selling related to carry trades. The degree of selling is still likely to be less than that seen during February and there will be the threat that the 115.0 level will be tested again given the structural inflows and potential for market tensions to return. 
                    
The yen strengthened to highs near 115.0 against the dollar during the week, a 12-week high for the Japanese currency, but weakened back to 117.50 as high-yield currencies staged a recovery. A  rebound in global stock markets helped undermine near-term demand for the yen as investor confidence recovered.

The latest capital account data recorded a net outflow of overseas funds for the first time in 8 weeks, but there was still an overall net inflow of capital.

There was little in the way of major economic data, although the core machinery orders recorded a firm 3.9% increase for January.

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Although market uncertainty over interest rates will persist in the short-term, the central bank bias is likely to be for a further increase in rates which will offer Sterling protection. Firrm buying appears unlikely as international funds are more likely to cut their heavily over-weight positions in Sterling rather than increase them further with the currency drifting weaker.  Overall, the UK currency is likely to hit selling pressure above the 1.94 level against the dollar.

Sterling weakened to lows below 1.92 against the dollar and near 0.6845 against the Euro early in the week. Sterling was subjected to heavy selling against the yen as carry trades were cut and pushed Sterling down on a trade-weighted basis.

Sterling was able to find renewed buying support over the second half of the week as markets regained confidence in high-yield currencies while UK data overall was solid.

The Bank of England left interest rates on hold at 5.25% following the latest MPC meeting and there was no statement following the decision.

The UK data was mixed over the week and failed to provide clear direction. The CIPS index for the services sector fell to 57.2 in February from 59.2 the previous month, but the latest surveys continued to suggest rising house prices.

Swiss franc

The Swiss currency will be vulnerable to fresh selling on yield grounds if there is a sustained drop in risk aversion. There is still a high risk that tensions will return and greater underlying caution should prevent the franc returning to recent lows. The National Bank is unlikely to accelerate the pace of monetary tightening, but is set to increase interest rates this month. Overall, the dollar will find it difficult to strengthen above 1.24 against the franc.
 
The Swiss currency strengthened to highs beyond 1.60 against the Euro before retreating. The franc also failed to hold gains to beyond 1.22 against the dollar with a retreat to 1.2280.

International trends remained the dominant currency-market influence over the week. A sharp reduction in carry trades strengthened the franc initially before confidence in high-yield currencies recovered later in the week.

The Swiss employment data remained strong with the seasonally-adjusted rate holding steady at 3.0% for February.  2006 GDP growth of 2.6% was the strongest since 2004. Inflation remained subdued according to the latest data. A 0.2% rise in March consumer prices cut the annual rate to 0.0%, the lowest for three years.

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The Australian dollar weakened to lows below 0.77 against the US dollar before a move back to near 0.78. Falling global stock markets weakened the Australian dollar on fears over an outflow of investment funds and weaker growth. Confidence revived over the second half of the week as equity markets and metals prices recovered.

As expected, the Reserve Bank held interest rate at 6.25% at the latest meeting. The Australian data was generally stronger than expected with fourth-quarter GDP growth of 1.0% despite a negative contribution from the rural economy.

The trade deficit narrowed to AUD-0.88bn from -AUD1.38bn the previous month which eased concerns over the near-term trade position.

The Australian dollar will find it difficult to secure further gains given that underlying investment flows are likely to remain at a lower level.
 
Canadian dollar

The Canadian dollar found support close to 1.18 against the US dollar, but struggled to sustain significant gains.

The Bank of Canada left interest rates at 4.25% at the latest policy meeting. The central bank was generally optimistic over growth, but retained a broadly balanced view on the economy and the likely outlook for interest rates. Domestic data failed to provide clear direction with PMI index strength offset by a drop in housing permits.

Commodity prices were an important influence, but the Canadian dollar found it difficult to take advantage of higher oil prices during the week.

The Canadian currency should be able to find further support close to the 1.18 level against the US dollar, but significant gains look unlikely.

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The Indian rupee weakened early in the weak with a fall to a 12-week low at close to 44.70 against the dollar. The rupee was undermined primarily by a sharp stock market fall to a five-month low. The decline increased fears that rising risk aversion would trigger heavy capital flows from India and put downward pressure on the currency.

There was a recovery in the stock market later in the week with the biggest one-day gain for 8 months and this helped strengthen the rupee back to around 44.35, although market caution over the local market remained at a higher level.

The rupee gained some support from a firmer Chinese yuan even though the Japanese yen weakened over the week as a whole which curbed rupee support.

Volatility levels are liable to remain higher in the short-term with wider capital account swings. Overall, there is scope for short-term support close to the 44.60 level

Hong Kong dollar

The Hong Kong dollar has been weak over the past week and fell to a 17-year low of 7.8175 against the US currency before a slight recovery. The currency was undermined by renewed arbitrage activity even though US yields remained at lower levels.

The Hong Kong dollar was undermined primarily by a sharp drop in the local stock market with fears of substantial capital outflows on overseas selling. The Hong Kong dollar struggled to recover even though there was a recovery in local equities.

The strengthening trend for the Chinese yuan failed to have a significant impact on the Hong Kong dollar. Overall, the currency is likely to remain weaker than 7.81 in the short-term, but should be able to resist further significant losses.