Weekly Forex Currency Review 09-11-2007

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Overall strategy:

The dollar will remain vulnerable in the short-term as sentiment towards the currency remains bleak with markets targeting further record lows. Nevertheless, there is scope for an important low to be reached late in 2007, especially with an underlying trade improvement. Risk tolerance are liable to remain lower in the short-term on persistent credit-related fears which will discourage carry trades. 

Dollar:

Confidence will remain depressed in the short-term with persistent fears that weakness in the housing sector, allied with on-going credit-related difficulties, will push the economy towards recession. There will also be expectations of further Federal Reserve interest rate cuts to support the economy. There is the potential for a further improvement in the underlying trade deficit even if high oil prices inflate the headline deficit and the Fed will need to take a balanced approach. Institutions will look for dollar selling opportunities, but there will be support on valuation grounds and G7 will look to prevent further sharp declines.    
      
The dollar has remained under pressure over the past week with further record lows against the Euro above the 1.47 level while the trade-weighted index also registered a fresh all-time low with the dollar struggling to find relief.

The dollar was unsettled by a call from a Chinese congressman that China should place a greater proportion of reserves into strong currencies such as the Euro. This revived fears over long-term diversification away from the US currency.

The US PMI index for the services sector strengthened to 55.8 in October from 54.8, but this failed to have a significant impact while prices rose less than expected.

Fed Chairman Bernanke warned that there were downside risks to the growth outlook as the housing sector was set to deteriorate further.

Bernanke also pointed to increased inflation risks, especially with a weak dollar pushing up import prices. He reiterated that policy decisions would be data dependent.

Other Governors reiterated support for the October Fed rate cut and suggested that rates could be cut again if necessary. Markets priced in a greater than 70% chance that the Federal Reserve would cut interest rates again in December.

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The ECB will continue to face policy conflicts in the short-term with concerns over an increase in headline inflation offset by greater doubts over growth trends. The latest evidence suggests a significant slowdown in growth which should encourage short-term ECB policy stability. The Euro will gain support on relative economic grounds, although there will also be doubts over the financial sector which will hamper the currency. Political protests against Euro strength will also increase if the economy deteriorates.

The Euro retained general strength during the week, although with a generally weaker tone against the low yield currencies, notably the Swiss franc.

As expected, the ECB left interest rates on hold at 4.00% at the latest council meeting. In the press conference, ECB president Trichet stated that the bank would act in a firm and timely manner. There was no use of the word vigilance to suggest a near-term increase in interest rates and Trichet suggested that inflation would fall next year.

Trichet stated that the recent Euro rise had been strong and abrupt, but there was an absence of more serious warnings with only a tangential reference to brutal moves.

There was a further increase in German industrial production, but factory orders fell sharply which increased speculation over an underlying economic slowdown. Similarly, the Euro-zone retail sales data was uninspiring with a 1.6% increase in the year to September while French industrial production fell by 1.1% for the month.

Yen:  

Domestic considerations will remain of secondary important in the short-term, but yield factors will tend to undermine the yen when risk tolerances stage a recovery. There will be further underlying concerns over credit-market conditions and the tightening of liquidity will provide important yen support. The short-term yen trends will tend to remain correlated with underlying stock market moves and heavy yen losses should be resisted with the Finance Ministry opposing rapid yen gains through the 110.0 level.                      
                    
The Japanese currency moves were dominated by global stock market moves and a sharp fall on Wall Street strengthened the yen to highs near 112.0. These was evidence of importer dollar demand close to the 112.0 level and equity market recoveries pushed the Japanese currency weaker at times.

The domestic machinery orders data was weak for the second successive month with a 7.6% September decline, although there was a marginal third-quarter increase.

Bank of Japan governor Fukui stated that rates should be increased in a timely manner, but there were no clear suggestions of a near-term tightening.

The Topix stock market index weakened to a three-month low and the increase in risk aversion pushed the Japanese currency stronger as global credit fears intensified.
 

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Sterling will gain further near-term support on yield grounds, especially with the Bank of England leaving interest rates on hold. The evidence already suggests a significant economic slowdown and there is still a high risk of a much sharper slowdown give housing vulnerability and credit tightening. Sentiment will deteriorate rapidly if growth indicators deteriorate, especially as there will be speculation that the bank has waited too long to lower borrowing costs. Even if near-term strength is sustained, the underlying risks are for a weaker currency.                     
 
Sterling proved resilient against the Euro during the week and strengthened to new 26-year highs against the US dollar with a peak above the 2.11 level.

The UK PMI data for the services sector recorded a drop to 53.1 from 56.7 the previous month and this was the lowest level since 2003. The total September trade deficit rose to GBP7.8bn, the widest deficit for the year.

The retail sales evidence was also weaker with the BRC reporting that like-for-like sales rose 1.0% in the year to October, the lowest reading for 11 months. Industrial production and manufacturing output both fell for September.

HBOS reported a 0.5% drop in house prices for October, the second successive decline for the index.

Despite the run of weaker data, the Bank of England left interest rates on at 5.75% following the latest MPC meeting. The bank issued no statement with the decision and the breakdown of the vote was also not disclosed.

Swiss franc:

The Swiss data has continued to suggest solid growth and also indicates that the economy is out-performing the Euro-zone. This combination will underpin the franc, especially as there is the possibility of a further increase in interest rates. The Swiss currency will remain correlated with global financial-market trends. The franc will gain further short-term support from sustained credit-related stresses, especially if global stock markets continue to weaken.       
 
The Swiss currency strengthened consistently against the Euro during the week with gains to near 1.65. A break of dollar support levels pushed the franc to highs around 1.1210 against the dollar which was the strongest franc level for over 20 years.

The Swiss unemployment rate held steady at 2.6% in the latest month while consumer confidence held steady. The KOF institute was optimistic over near-term economic prospects, but expected a slowdown over the next two quarters. The OECD stated that interest rates may need to be increased further.

The Swiss franc secured support from the increase in risk aversion and a general decline in stock markets over the week.

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The Australian dollar pushed to highs around 0.94 against the US currency after the Reserve Bank interest rate decision. The currency then dipped back towards 0.92 as a sharp drop in global stock markets increased risk aversion levels.

The Reserve Bank met market expectations with an increase in interest rates to 6.75% from 6.50% following the latest policy meeting. The bank also took a firm stance on inflation which suggested it would maintain a tightening policy bias.

The unemployment rate rose to 4.3% in October with the employment increase held to 12,900, although there was a sharp rise in full-time employment which underpinned sentiment. Housing finance weakened significantly for September.

The Australian currency still gained some support from the level of commodity prices, although volatility was a feature.

Short-term support on yield grounds will be offset by a general increase in risk aversion and reduced carry trade related inflows with volatility liable to stay higher and the risk of a more substantial correction.

Canadian dollar:

The Canada dollar remained very strong over the first half of the week and strengthened to 50-year highs near 0.9050 against the US dollar on Wednesday. The Canadian currency then dipped sharply back towards the 0.94 level.

The currency gained initial support from a strong set of labour-market data at the end of last week. The data this week was less impressive with a drop in housing starts, although the PMI index remained firm for October.

The Canadian government voiced greater concern over the currency with Prime Minister Harper stating that the rapid gains required a period of reflection over exchange rate policy. The Bank of Canada also voiced concerns that the currency had appreciated so fast over the past few weeks.

The principal short-term feature is liable to be high volatility as Canadian officials look to talk the currency back down to more sustainable levels.

Indian rupee:

The rupee pushed to the strongest level for close to 10 years during the week with a high close to 39.15 against the dollar.

The rupee edged weaker later in the week, unsettled to some extent by continuing stock market volatility with market activity curbed by a market holiday on Friday.

The Reserve Bank of India intervened to restrain the rupee. The central bank also increased the ceiling on its market stabilisation bonds to INR2.5trn from INR2.0trn which gave the bank more scope for intervention if required.

Overall rupee confidence should remain firm in the short-term. There will, however, be the risk of increased volatility, especially if credit conditions continue to tighten.   

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The Hong Kong dollar was unable to make a fresh attack on the 7.75 level against the US currency during the week. The currency weakened significantly to lows beyond 7.7750 on Friday.

There was an increase in domestic liquidity which pushed local money-market rates lower. Three-month rates, for example, dropped to lows below 3.5% which encouraged arbitrage activity and undermined the local currency.

The Hong Kong dollar was unsettled temporarily by a sharp drop in the Hang Seng index after the Chinese authorities suggested that there would be delays to plans to allow direct Chinese involvement in the Hong Kong market.

HKMA chief Yam stated that there was scope for the to enhance the currency regime, but that the regime would not be fundamentally changed.

The Hong Kong dollar will find it difficult to regain momentum while local interest rates remain at low levels. There is, however, still a small risk of a wider trading band.

Chinese yuan:

The yuan strengthened at a faster pace against the US dollar over the latest week with a peak close to 7.41 against the US dollar on Friday. The yuan was still not strong on a trade-weighted basis given the wider dollar losses.

The central bank was comfortable with allowing a stronger yuan and the bank allowed a longer series of daily gains than has been seen over the previous few months.

Initially, the NDF markets did not move significantly with some speculation that global stock market volatility was discouraging speculative activity, but the NDF rates strengthened sharply on Friday.

The latest central bank monetary report highlighted the inflation risks and there will be persistent speculation over a further near-term tightening of monetary policy.

The yuan is likely to strengthen further, although the central bank is now likely to encourage a period of greater stability after recent more rapid gains. There remains the possibility of a one-off revaluation.