Weekly Forex Currency Review 12-10-2007

Overall strategy

Dollar confidence will remain fragile in the short-term with speculation that there will be further Federal Reserve interest rate cuts which could compromise medium-term inflation control.  Nevertheless, the overall evidence suggests that the US currency should be close to a near-term trough given the amount of bad news priced in.  Carry trade volatility is liable to increase again.         

Key events for the forthcoming week

Dollar

Dollar confidence will remain weak in the short-term with unease over US economic trends. In particular, there will be persistent fears over a further deterioration in the housing sector. The Federal Reserve October decision remains open, but the overall market suspicion is that the Fed will err on the side of further interest rate cuts to support the economy.  There will be further pressure on the US Treasury to provide more robust backing for the dollar to avoid a further deterioration of international sentiment.  A gradual improvement in the trade account should reinforce some support on value grounds and some dollar correction is realistic if the Fed holds steady.
      
The dollar has failed to hold rally attempts during the past week and dipped to lows beyond 1.42 against the Euro. The US currency was more resilient against other major currencies and trading conditions turned increasingly choppy.

Following the stronger than expected employment data at the end of last week, markets cut the chances of an October interest rate reduction to around 40%.

The FOMC minutes confirmed that GDP growth and inflation forecasts had been downgraded. The Fed was concerned over the housing sector and stated that future policy would be dependent on the economic data.

There was still a strong suspicion that the Fed would err on the side of a further cut in rates with markets pricing in a 70% chance of a fourth-quarter cut.

There were mixed comments from Fed governors, although the overall remarks indicated reduced fears over inflationary pressures. Fed officials and US Treasury Secretary Paulson made some warning remarks over the weak dollar.

The US trade deficit fell to US$57.6bn in August from a revised US$59.0bn the previous month with the underlying deficit continuing to decline.

US jobless claims fell to 308,000 in the latest reporting week from a revised 320,000 previously while housing foreclosures edged slightly lower for September.

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The ECB will remain concerned over inflationary pressure, especially with high energy prices, and will therefore be reluctant to drop its tightening bias on interest rates. The Euro-zone economic data is liable to remain mixed and the net risk is for a significant slowdown in growth. There will be increasing concern over the impact of a strong Euro if demand falters. There will also be pressure for more aggressive central bank co-ordinated efforts to prevent further rapid Euro gains at the forthcoming G7 meetings.             

The Euro has had a strong tone over the week, especially against the yen and Swiss franc while it also rebounded strongly from retreats against the dollar and Sterling. There was a partial retreat from highs against the dollar and yen late in the week.

The industrial-sector data was generally firm with solid manufacturing output increase for France and Italy. The Sensix index of wider Euro-zone confidence fell again for September, although the rate of decline slowed.

The ECB was concerned over inflationary pressure with Bundesbank head Weber stating that the bank may need to pursue a restrictive policy.

ECB officials continued to warn over excessive currency movements. Their main focus was on the need for Asian currency gains rather than protesting against the dollar's value.

Eurogroup head Juncker warned that intervention did not have to wait for the G7 meetings from October 19. The Euro dip in US trading on Thursday invited some speculation over covert central bank intervention.

Yen

The Bank of Japan did not increase interest rates at the October meeting and the yen will, therefore, remain vulnerable to selling pressure on yield grounds, especially if global risk tolerances remain high. There will still be reservations over aggressive asset allocations overseas which will provide some protection. There will also be further pressure for stronger Asian currencies to ease upward pressure on the Euro. Overall, the yen should be able to avoid heavy selling even if carry trades trigger further short-term losses.                     
                    
The yen has tended to weaken as fresh enthusiasm for carry trades has increased capital outflows. The dollar and Euro both pushed to two-month highs with the US currency peaking around 117.80 with Euro gains to 167.70.

The Bank of Japan left interest rates on hold at 0.50% following the latest policy meeting by an 8-1 vote with the dissenter calling for higher rates.

Bank Governor Fukui repeated his comments that policy should be adjusted gradually with some hints over that a December rate increase was realistic.

The industrial data was subdued with a core 7.7% drop in machinery orders for August to give a 2.6% annual decline. The current account remained in strong surplus with a JPY2.08trn August surplus, although this was lower than expected.

The yen was still undermined by fresh interest in carry trades with the capital account recording net outflows in the latest week.

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The housing sector will remain an important focus given the risk of a sharp deterioration and there will be further speculation over a significant slowdown in the economy. The Bank of England is still concerned over inflationary pressure and will be reluctant to sanction a near-term policy easing, but pressure for a cut is liable to increase over the next few weeks. Overall capital account trends are also liable to be weaker with a reversal in underlying merger flows. A sustained reversal would tend to undermine Sterling and overall depreciation remains likely even with carry trades providing some short-term protection.                  
 
Sterling has remained volatile over the past week with choppy trading against the dollar and Euro. The UK currency rallied to near 0.69 against the Euro before weakening sharply back towards 0.70. The UK currency also failed to hold above 2.04 against the dollar.

There was some evidence of Sterling selling associated with the RBS-led takeover for ABN Amro and underlying investment flows appeared negative.

The latest RICS survey of agents reported a net balance of 14.6% reporting a drop in house prices for September from a revised 3.3% the previous month which was the weakest survey for two years.

There was a stronger reading for retail sales with a 3.0% like-for-like annual increase according to the British Retail Consortium (BRC), although confidence in future spending trends deteriorated.

Input producer prices rose strongly in September with a 3.2% monthly increase, but output increase was subdued with a core annual increase of 2.2%. Industrial production edged stronger with a 0.1% increase for August. The trade deficit fell to GBP6.85bn from an upwardly-revised GBP7.4bn in July.

Swiss franc

National Bank warnings over the economic uncertainties will tend to curb franc support in the short-term, especially with speculation that the bank may decide against a further interest rate increase. The central bank will be concerned over inflationary pressure and officials will be uneasy over further franc weakness against the Euro. The Swiss currency will tend to weaken if there is a sustained revival in carry trade interest and a flow of funds into high-yield currencies, but these trends could reverse quickly given underlying credit stresses.       
 
The Swiss currency weakened sharply against the Euro during the week with lows beyond the 1.68 level before a partial recovery. The franc edged slightly weaker against the dollar in choppy trading.

National Bank Governor Roth expressed some concerns over the economy with downside risks evident. The central bank also indicated that interest rates were in a wait and see mode.

The franc was undermined by the strength of risk tolerances with a flow of funds into high-yield and commodity currencies during the week.

The unemployment rate, however, fell to a seasonally-adjusted 2.6% from 2.7%.

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The Australian dollar tested 23-year highs above 0.90 against the US dollar with a peak around 0.9050. There was a limited correction weaker on Friday.

The Australian dollar drew support from commodity price trends during the week and strong capital flows into Asian markets.

The employment data was mixed with a lower than expected employment increase of 13,000 for September while the unemployment rate fell to 4.2% from 4.3%. The housing data was missed while consumer confidence held steady for September.

The Australian currency should remain firm in the very short-term on yield grounds, but will increasingly be exposed to the risk of a sharp correction.

Canadian dollar

The Canadian dollar has remained firm against the US dollar with gains to highs beyond 0.9750 as firm currency sentiment combined with weak US dollar confidence.

High oil prices continued to provide important background support to the Canadian currency with crude prices close to record levels.

The trade surplus rose to CAD4.1bn from a revised CAD3.4bn the previous month with exports and imports edging lower over the month

There is likely to be increasing pressure for a more substantial Canadian dollar correction weaker even if the currency remains firm in the very short-term.

Indian rupee

The rupee has remained strong over the past week and tested the highest levels since 1998. The rupee strengthened to high around 39.27 against the US currency before edging slightly lower on Friday.

The flow of funds into the local stock market remained a very important focus with reported net inflows during October alone of at least US$2.5bn.

The central bank intervened to curb currency gains during the weak and looked to offset the impact of rupee sales on domestic inflation pressures. Weaker than expected earnings from Infosys Technologies maintained some concerns over the competitive position

There will be a growing risk of a sharp stock market correction and there is also likely to be at least a limited rupee correction even with strong near-term confidence.

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The Hong Kong dollar has remained strong during the week. The local currency strengthened to 17-month highs around 7.7525 against the US currency on Friday.

The local money markets remained tight with persistent IPO-related demand. The high level of local interest rates supported the currency with one-week rates around six-year highs of 5.80% which supported the Hong Kong dollar.

The Hang-Seng stock market index rose to record highs with powerful capital inflows and this helped support the Hong Kong dollar.

The currency should remain firm in the short-term on capital inflows, but there is scope for some correction weaker as interest rates should ease from recent peaks. There is still a small risk of a fundamental currency revaluation.

Chinese yuan

The Chinese markets re-opened after a one-week holiday. There was a temporary widening of the NDF rates as markets speculated over a faster rate of yuan appreciation over the next few months

The central bank, however, pushed the yuan sharply weaker on Tuesday and there was further evidence that it was blocking gains through 7.50 against the dollar.

The trade account remained strong in August with a US$23.9bn surplus from US$25.0bn in July.

There was further pressure from European officials to accelerate yuan gains, but officials gave no indication that there would be a major short-term policy shift.

There will be further underlying pressure for a stronger yuan and the most likely outcome is that the bank will continue to sanction a slow advance, although there remains a small possibility of a revaluation.