Weekly Forex Currency Review 10-08-2007

Overall strategy

Risk tolerances, the extent of credit fears and shifts in carry trades will remain extremely important in the short-term. Volatility levels are likely to remain higher, especially with liquidity levels lower. The US dollar will gain some important support from higher risk aversion on liquidity grounds, but is not in a position to secure strong gains.  

Key events for the forthcoming week

Dollar

Sentiment towards the US economy stabilised after the Federal Reserve statement, but there will be further unease over the housing sector with mortgage difficulties remaining a key concern. There will also be further unease over a potential slowdown in the consumer sector. The industrial sector should still be firm and markets are discounting a cut in interest rates late this year which should provide some dollar protection. The net impact of increased risk aversion will still provide some support to the US currency, especially given the high US market liquidity.   
      
The dollar weakened to lows around 1.3825 against the Euro before recovering strongly on Thursday as liquidity concerns prompted a flight to quality. Similarly, the trade-weighted index fell to a 15-year low below the 80.0 level before a recovery.

Following the weaker than expected employment report at the end of last week, there was little in the way of data releases this week. Unit labour costs rose 2.1% in the second quarter from an upwardly-revised 3.0% in the first quarter to give an annual increase of 4.5% which maintained underlying inflation concerns

The Federal Reserve left interest rates at 5.25% following the latest FOMC decision. In the statement accompanying the decision, the Fed stated that inflation was still the pre-dominant concern. Members also stated that downside risks to growth had increased somewhat with an on-going adjustment in the housing sector.

Markets continued to speculate over an interest rate cut late in 2007 with markets pricing in a cut by the end of October as credit-related stresses increased.

Dollar moves were also correlated strongly with levels of risk tolerances as the US currency came under pressure at times of greater market interest in high-yield currencies. Risk aversion supported the dollar late in the week.

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At this stage, the ECB is still on track for an interest rate increase at the September meeting, but uncertainty will increase. The fund losses and rumours of European bank difficulties will trigger some speculation that the ECB will decide to postpone a September rate increase to let credit markets stabilise. Markets have also priced in two interest rate increases by early next year which will leave the Euro vulnerable to selling pressure on any shift in expectations, especially if the consumer and property-related sectors show signs of stresses.             

The Euro strengthened by mid-week on confidence that interest rates would be increased, but weakened on Thursday as credit fears spread to Euro-zone markets. The Euro weakened to lows near 1.3650 against the dollar from highs around 1.3820.

The Euro was unsettled by rumours of liquidity difficulties and losses at German banks together with news that three BNP Paribas funds had suspended withdrawals. The ECB injected extra liquidity to calm money markets during Thursday after a spike in interest rates.

Over the first half of the week, the ECB continued to take a tough stance on interest rates and inflation in public comments.

German experts remained robust in the latest trade data, but the data releases were of secondary importance over the week as risk conditions dominated.

Yen  

The domestic influences will remain of secondary importance in the short-term, with reduced expectations of an August interest rate increase undermining the yen slightly. Global influences will remain dominant and any further unwinding of carry trades would provide important yen support, especially given the risk of position capitulation. In the short-term, there will still be strong retail yen selling interest which will lessen the potential for yen gains. The key short-term feature is likely to be a sustained increase in volatility.             
                    
The yen remained prone to high volatility during the week. After gains to 117.0 against the dollar the yen weakened to 120.0 as high-yield currencies recovered.  There were fresh yen gains late in the week with a move back to around 118.0.

Japanese currency moves were dominated by the levels of risk aversion and changes in stock market conditions as there were sharp swings in sentiment.

There was a sharp drop in reported machinery orders for June and, although the Bank of Japan continued to take a generally optimistic view over the economy, expectations over an August rate increase faded as market stresses increased.

The latest capital account data recorded a net flow of funds out of Japanese stocks, but the capital account data overall was more favourable.

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The Bank of England will look to increase interest rates to 6.0% to curb inflation. An increase is already built into Sterling valuations and further market turmoil could delay an increase which would undermine the currency. There are also serious risks associated with the housing sector which will expose the UK currency to underlying selling pressure. Sterling will continue to be strongly influenced by developments in carry trades and the market stance is likely to remain more defensive. Overall, the UK currency is still liable to weaken over the next few weeks.           
 
Sterling weakened to two-month lows against the Euro around 0.6815 before recovering to 0.6775 while the UK currency had a weaker net bias against the dollar in very choppy trading with lows below 2.02 from a high near 2.04.

Currency moves were correlated strongly with carry trade developments and stock market trends. The UK currency rallied against the dollar in mid week as risk tolerances improved before weakening sharply again.

In the quarterly inflation report, the Bank of England stated that the inflation risks had increased. It also stated that a further increase in interest rates to 6.0% would ensure that the inflation target of 2.0% would be met in two years time.

Bank Governor King took a firm stance on interest rates downplaying the credit-related risks and recent market turbulence. Expectations of an increase in rates was hardened by the inflation report before market turmoil created some doubts.

The UK industrial data recorded a 0.1% monthly production increase for June while the trade deficit narrowed to GBP6.3bn for June, an 18-month low. The data failed to have a big impact with markets focussing on yield considerations and carry trades

Swiss franc

The Swiss economic trends are likely to remain favourable in the short-term with firm growth and the potential for a further interest rate increase in September. Global risk conditions will tend to remain dominant in the short-term and the switch into more defensive currencies will continue to support the franc. A further increase in risk aversion could trigger forced position closure and rapid Swiss currency gains, especially if Euro-zone economic concerns increase.
 
The Swiss currency strengthened sharply against the dollar to highs near 1.18 before weakening back towards 1.20. The Swiss currency found good support weaker than 1.65 against the Euro with a move to 1.6350. 

Swiss currency moves continued to be influenced strongly by global market moves and the degree of fear over carry trades. The franc weakened as global stock markets recovered ground before regaining ground strongly later in the week

The seasonally-adjusted unemployment rate was unchanged at 2.7% in July, reinforcing the fact that the economy is sound, even though the consumer confidence index weakened slightly for the month.

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The Australian dollar initially recovered from lows below 0.85 against the dollar to challenge 0.8650 before fresh selling pressure triggered a slide to lows near 0.84.

The Reserve Bank of Australia increased interest rates to 6.50% from 6.25% at the latest council meeting. The bank retained a tightening policy bias, but was slightly more cautious over the outlook. The unemployment rate remained at the low level of 4.3% for July while there was a firm 21,800 increase in employment for the month.

Australian dollar moves were still influenced strongly by carry trades and the swings in high-yield currencies. Lower commodity prices unsettled the Australian currency on Thursday and Friday as risk aversion and growth fears had a negative impact.

Volatility is liable to remain higher in the short-term and the net risks point to underlying Australian dollar losses, although there will be significant rallies at times.

Canadian dollar

The Canadian dollar strengthened to test levels beyond 1.05 against the dollar before weakening sharply to 1.06 in volatile trading. There was little in the way of domestic economic data releases during the week

Oil prices provided initial Canadian dollar support, but energy prices weakened over the second half of the week as crude prices dipped towards the US$70 p/b level.

The Canadian currency was influenced strongly by the level of carry trades and risk aversion. Fresh market turmoil on Thursday pushed the Canadian dollar weaker as there was a retreat from high-yield currencies.

Expectations of further interest rate increases will provide Canadian dollar support, but carry trades will tend to remain dominant in the short-term and limit any gains.

Indian rupee

Indian rupee volatility has increased as global volatility has intensified although, given the underlying stresses, rupee moves were still contained. The Indian currency strengthened to near 9-year highs before weakening sharply to 41.0 with the currency close to 40.65 on Friday.

The rupee gained initial support from a recovery in the local stock market, but there was renewed losses for the bourse late in the week which undermined the currency.

The central bank increased the amount of MSS bonds which can be issued which suggests that intervention to curb rupee gains will be sustained. The bank also imposed tighter restrictions of foreign borrowing which will tend to curb capital inflows and restrain rupee gains.

There was heavy exporter selling when the Indian currency approached the 41.0 level against the US currency.

Volatility levels are likely to remain higher in the short-term with the net trend likely to be for rupee depreciation, although losses should still be contained.

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The Hong Kong dollar was trapped close to the 7.83 against the US currency during the first half of the week with the local currency struggling to combat the impact of arbitrage activity.

Renewed turmoil in global stock markets had some negative impact on the Hong Kong currency with a withdrawal of funds from the local stock market.

Inter-bank rates rose sharply on Friday as regional credit stresses increased and this helped reverse arbitrage activity with the Hong Kong dollar strengthening to highs around 7.8150 before a move back to 7.82.

The currency trend is likely to remain dominated by arbitrage activity in the short-term. Overall, the Hong Kong dollar should be able to resist losses beyond 7.83, but gains from current levels should be limited.

Chinese yuan

The Chinese yuan has been unable to make headway against the dollar with the central bank continuing to resist pressure for faster appreciation. The yuan edged weaker to 7.5770 on Friday.

There was evidence of weaker yuan demand by exporters which helped restrain the currency while there was a reduction in speculative inflows late in the week as regional risk aversion increased sharply.

The Chinese yuan was supported by speculation over a trade war between China and the US. There was also speculation over a high consumer inflation figure next week which could trigger a further tightening by the central bank

In response, the rise in market interest rates pushed the NDF forwards to the widest level since the yuan was allowed to float in 2005 before the Friday reversal.

The Chinese currency is still likely to appreciate gradually, especially if there is a high inflation reading and a one-off revaluation is a possible policy response.