Weekly Forex Currency Review 09-12-2011

The Euro-zone debt crisis will continue to dominate in the short-term and there will be a high degree of uncertainty over whether there has been sufficient progress at this week’s Summit to stem selling underlying pressure. If the Summit is deemed to have failed, then there will be the risk of severe tensions in Euro-zone markets and a wider deterioration in risk global appetite which would provide important defensive dollar support.

Key events for the forthcoming week

Dollar:

The US economic data will maintain a slightly more optimistic tone towards the short-term outlook, especially with solid gains in the labour market. There will still be a very cautious tone, especially with some budget support measures due to expire at the end of the year.  The Federal Reserve will also maintain a highly-expansionary monetary policy and is likely to indicate that there will be scope for further monetary support measures if required.  International considerations will remain extremely important for the US currency and there will be demand for the dollar when risk appetite deteriorates sharply.

Following a slightly better than expected employment report at the end of last week, attention was focussed firmly on the Euro-zone and dollar trends were driven to a large extent by developments in risk appetite.  After weakness during the middle of the week, the US currency was able to regain some significant traction as confidence faltered again as it gained against European and commodity currencies.

The US ISM services-sector index was weaker than expected with a decline to 52.0 for November from 52.9 previously. Orders gained slightly for the month, but there was an unexpected retreat in the employment index back to below the 50 level. The data overall served to dampen optimism surrounding the US economy.

In contrast, there was a drop in jobless claims to 381,000 in the latest week from 402,000 previously and this provided a brief boost to risk appetite with markets also looking ahead to next week’s Federal Reserve interest rate decision.

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The Euro-zone situation will continue to be monitored very closely in the short-term amid serious fears that there could still be an underlying break-up in the currency area.  There will also be fears surrounding the banking sector as funding difficulties continue. Although the ECB has cut interest rates and boosted liquidity, there will be pressure for more aggressive action to provide support.  The EU Summit will be extremely important for sentiment and there may be some initial relief, but there will still be an important underlying lack of confidence in the outlook.

The Euro gained support at times, but it was unable to sustain gains and tested support below 1.33 against the dollar.  Following Standard & Poor’s warning over European credit ratings, there was also a warning that the AAA EFSF rating could be at risk if there were any downgrades to ratings for individual Euro-zone countries.  

There were further tensions within the banking sector as funding remained extremely tight. Central banks held their first liquidity auctions since last week’s announcement of lower swap rates and the lower rate triggered a big increase in demand for dollars with over US$50bn in funds for the three-month tender. With Libor rates increasing to 0.54%, the cost of securing liquidity from central banks was only slightly higher than from the market. There were also warnings from the German government that it could force recapitalisation on the banks.

The ECB outcome was in line with consensus expectations as the central bank cut the main financing rate to 1.00% from 1.25%, matching record lows, although the vote was not unanimous with some members preferring to wait.

There was a reduction in GDP growth forecasts by the ECB and there was general pessimism surrounding the outlook. The central bank announced that it would introduce new three-year repo operations to provide long-term liquidity to the banking sector. There was also a relaxation in collateral to allow a wider range of securities.

There were very important comments surrounding bond purchases with Draghi maintaining the orthodox line that it was not the ECB’s role to provide monetary financing for government deficits. These comments seriously dampened market expectations that the ECB would be willing to provide increased support and the Euro dropped sharply following the report as Italian yields spiked higher. It remains to be seen whether there will be a change in tone following the Summit.

As EU Leaders gathered for the Summit meeting, there were further tensions surrounding the introduction of majority voting for the ESM which is due to replace the EFSF in 2012.  A draft agreement indicated that any Treaty changes would be limited to the 17 Euro-zone states rather than the 27 EU members. There was also an agreement that the ESM should not be given a banking licence while bailout decisions would be taken on a 85% majority.

Yen:

Safe-haven considerations will remain extremely important in the short-term and there will be underlying defensive support for the Japanese currency, especially with a lack of viable alternatives given the continued Swiss determination to resist currency gains.  There will also be the potential for capital repatriation by major institutions. There will be domestic pressure to weaken the yen, especially if there is a downturn in the regional economy and there will also be fears surrounding capital spending.   

The yen resisted losses during the week and strengthened to a peak around 77.10 against the dollar on Thursday.  There was some recovery in the dollar later in the session as it rallied back to the 77.70 area while the Euro remained generally on the defensive with lows near 103.0.

The trading pattern was different from recent sessions as the yen held firm when risk appetite was firm and the very tight correlation with the dollar faded slightly as the dollar was also able to advance against the yen as the Euro fell.

Third-quarter Japanese GDP rose a revised 1.4% from 1.5% previously as capital spending estimates were downgraded slightly, although the underlying impact was limited. The Japanese economic data was weaker than expected with a further 6.9% decline in core machinery orders for November following an 8.2% decline previously. The series is volatile, but there will be further concerns surrounding the outlook

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Confidence in the UK economic outlook is liable to deteriorate further with fears over another recession, especially given the Euro-zone downturn. The budget outlook has weakened further and there will be severe debt implications if there is a further downturn in the economy. There will also be speculation over additional Bank of England quantitative easing once the current round of bond purchases is completed in February.  There could be further near-term defensive Sterling demand as an alternative to Euro-zone assets, although these flows could suddenly reverse if doubts escalate and there are increased credit-rating fears.

Sterling was little changed for the week as a whole as it failed to hold gains against the dollar and tested the 1.56 area, but it did strengthen to one-month highs against the Euro. There was some initial relief following the latest PMI services-sector report with the index edging high to 52.1 for November from 51.3 previously.
 
The Bank of England announced a new precautionary liquidity operation which would be used in the event of credit conditions deteriorating further, although the bank was keen to emphasis that there were no liquidity difficulties at present.  

There was no surprise from the Bank of England on Thursday as interest rates were left on hold at 0.50% while the quantitative easing amount was also unchanged at GBP275bn. As usual when there is no policy change, there was no MPC statement.

There will be speculation of political isolation surrounding the EU Summit and, much more damagingly, there will be fears that the UK economy will be damaged severely by any Euro-zone break-up. Safe-haven demand for Sterling will continue to be a key component and there will be expectations of further defensive inflows despite fears over the UK outlook. The principal feature is likely to be high volatility.

Swiss franc:

The National Bank will remain determined to protect the minimum Euro level against the franc with further verbal intervention. There have also been further hints that the bank could make official interest rates negative in an attempt to deter capital inflows. There will be the risk of a renewed surge of capital into Swiss institutions if Euro-zone fears intensify and the bank’s policies could still be severely tested. High volatility is likely to remain an important feature.

The dollar briefly dipped to lows below 0.91 against the franc before quickly regaining ground. The currency was still blocked in the 0.93 area as progress was dampened by a firmer franc tone against the Euro.
The latest consumer prices data was weaker than expected with a 0.2% decline for November compared with expectations of a 0.1% increase.  The data increased market speculation over deflation within the economy and also increased expectations that the National Bank would look to push the franc even weaker in order to counter the potential deflation threat.

There was some disappointment that the National Bank had not moved to weaken the franc and the ECB rate cut also provided some support for the franc, although the net impact was measured. There were comments from the Finance Ministry that Switzerland was still considering the possibility of negative interest rates to deter any flows into the Swiss currency. There were also comments that there was a plan to deal with any surge in capital inflows if Euro-zone fears intensify.

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The Australian dollar was subjected to choppy trading during the week and did gain strongly at times, but it was unable to sustain the advance and dipped back to below 1.01 against the US dollar late in the week as international tensions persisted. Although risk conditions were resilient for much of the time, there was still a high degree of caution and unease surrounding the global growth outlook.

The Reserve Bank sanctioned a second successive interest rate reduction with a cut to 4.25% from 4.50% as it responded to expectations of weaker growth. The GDP data was close to expectations while the labour-market data was weaker as there was an employment decline of over 6,000 for November.

The Australian dollar will continue to be subjected to high volatility and it will be difficult to sustain gains given the underlying trends in risk appetite.

Canadian dollar:

The Canadian dollar maintained a generally firm tone for much of the week and tested levels near 1.0050 against the US dollar before a retreat back to the 1.0250 region.

The Bank of Canada left interest rates on hold at 1.0% and warned over the external threat to growth, but it also stated that monetary conditions were accommodative.

Concerns over the global growth outlook put downward pressure on equities and stocks late in the week which also undermined the Canadian currency.

The Canadian dollar will be vulnerable to selling pressure given the global risk conditions, although confidence in the fundamentals will offer support.

Indian rupee:

Although the rupee was able to maintain a steadier tone for much of the week, the currency was unable to make much headway and there was selling pressure late in the week with a renewed test of support near the 52 area against the US dollar.

There was steady dollar demand from importers which undermined the currency. The Reserve Bank suggested that it would be very slow to relax monetary policy given persistent inflation fears which also dampened capital flows into the stock market, especially with doubts surrounding structural reforms.

The rupee trends will continue to be influenced strongly by trends in risk appetite and it will be difficult to secure more than a limited recovery in the short-term.

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The Hong Kong dollar found it difficult to make further progress during the week and consolidated around the 7.7750 area against the US dollar as trading volumes started to dip sharply ahead of the year-end period.

There was underlying caution surrounding risk appetite, especially with a lack of conviction in the Chinese outlook which dampened demand for the local currency.

Risk conditions will continue to dominate Hong Kong dollar moves in the short-term Evidence of further weakening in the mainland will also restrain any potential gains.

Chinese yuan:

The PBOC maintained a steady tone for the yuan and attempted to push the central rate slightly stronger with a figure close to 6.3350 against the US dollar. Market demand for the yuan remained weaker and it dipped to the lowest permitted level within the trading band throughout the week on speculation over capital outflows with a spot rate weaker that 6.3650 on Friday.

There were further concerns surrounding a slowdown in the economy and a cautious attitude towards risk also encouraged capital outflows from the yuan. The latest inflation data recorded a decline in consumer inflation to 4.2% from 5.5% previously, encouraging expectations of monetary easing.

Speculation surrounding a weaker economy and the possibility of further monetary easing will tend to keep the yuan on the defensive in the short-term.