Weekly Forex Currency Review 14-12-2007

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Overall strategy: There is likely to be some short-term relief over US economic trends and there is scope for a further corrective recovery, but underlying sentiment will remain cautious at best given fears surrounding the housing sector. Erratic trading conditions will be an important feature over the year-end period as liquidity levels will tend to drop. Underlying global credit fears will persist despite central bank efforts to alleviate market pressures.                     

Key events for the forthcoming week

Dollar:

The latest retail sales data will tend to ease immediate pessimism over the US economy while there will be optimism that a combination of interest rate cuts and actions to boost liquidity will help support the economy. There will also be optimism over investment flows into the US economy on valuation grounds which will encourage some correction of aggressive short speculative positions. There will still be underlying fears that the economy will slide towards recession and yield support will remain weaker. Potential reserve diversification by global central banks will continue to be a barrier to a strong dollar recovery.    
      
Despite significant interim fluctuations, the dollar did not move substantially over the week as a whole. The dollar pushed to test levels stronger than 1.46 against the Euro and strengthened on a trade-weighted basis as sentiment improved slightly.

Following the latest FOMC meeting, the Federal Reserve cut the Fed Funds rate by a further 0.25% to 4.25% . The discount rate was also cut by 0.25% to 4.75%.

In the statement accompanying the decision, the Fed stated that uncertainty over growth and inflation had increased. There were also comments that consumer spending and business investment and shown signs of weakening slightly while the housing adjustment was intensifying.

Core inflation was described as under control, but there was still unease over potential pressures. Headline producer prices also rose very strongly by 3.2% in November, the highest increase for over 30 years as energy costs increased, although the underlying increase was held to 0.4% for the month.

As liquidity conditions remained very tight, the Federal Reserve announced a series of fresh liquidity injections. A wider range of collateral would be accepted and the interest rates would not be set at penal rate in an attempt to free up the credit markets.

The US trade deficit increased slightly to US$57.8bn for October after a revised US$57.1bn the previous month as higher oil prices put upward pressure on imports.

Retail sales rose strongly by 1.2% in November while there was a 1.8% underlying increase. Although sales were boosted by a strong rise in gasoline sales, there was still a solid underlying increase which boosted confidence over spending trends.

There were rumours of a small revaluation for Middle East currencies, but there were no actual policy change announcements.

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The ECB will continue to fret over inflation pressures in the short-term, especially as near-term inflation data will stay significantly above target. The bank will still find it difficult to sanction a monetary tightening given unease that credit stresses will undermine growth. Indeed, there is the risk that confidence in the Euro-zone economy will deteriorate further, especially as property-related stresses will persist. The Euro should be able to avoid heavy selling pressure, but will remain vulnerable to corrective pressures.    

The Euro had a mixed performance over the week against the major currencies with a solid tone against the low-yield currencies.

The German ZEW index weakened to the lowest level since 1993 at -37.2 while the Sentix index also drifted lower and the ZEW institute warned that the strong Euro was having a damaging impact while growth was faltering.

The industrial data recorded small increases in output for October, although the data did not have a significant market impact.

ECB officials continued to warn over inflation risks in the economy during the week, although the confidence in growth prospects was generally lower.

Yen:  

Confidence in the Japanese economy will remain fragile in the short-term with expectations that the Bank of Japan will continue to delay an interest rate increase. The short-term yen moves will remain dominated by levels of risk aversion and any central bank success in alleviating liquidity stresses would tend to undermine near-term yen support. There will still be fears over the impact of a credit contraction and unease over a sharp downturn in the global economy should also provide important yen protection.
                    
The Japanese currency had a generally weaker tone during the week with the Japanese currency dipping to six-week lows against the dollar above 112.00. The yen also tested the 165.0 level against the Euro before recovering ground.

The yen gained strongly after the Federal Reserve discount rate was held at 0.25%. The Japanese currency then weakened sharply after the global central banks announced their plans to inject additional liquidity into markets to ease credit constraints and the currency struggled to regain buying support.

The Tankan index for major manufacturers fell to +19 in December from +23 the previous month which undermined confidence in the economy, although capital spending plans were revised up.

The current account remained in strong surplus for October while wholesale prices rose 2.3% over the year, the highest figure for 2007. A strong recovery in core machinery orders after two monthly falls failed to have a significant impact.

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Confidence in the UK economy will remain fragile in the short-term with fears that a downturn in the housing sector, allied with tighter credit conditions and financial-sector weakness, will trigger a serious deterioration in the economy. The Bank of England will remain concerned over inflation pressure and will, therefore, be very wary over cutting interest rates again quickly, but pressure for a move is likely to intensify over the next few weeks. The overall risks still look to be for Sterling depreciation.  
 
Sterling secured further support weaker than 0.72 against the Euro over the week while the UK currency was also generally resilient against the dollar with a test of resistance levels above the 2.05 level before a renewed test of support below 2.04.

The housing data remained weak with the RICS index recording a further drop to -40.6% in November from -23.4% previously which was the weakest reading for over two years as underlying confidence in the housing sector continued to deteriorate.

The labour-market data was firmer with unemployment falling by a further 11,000 for November. Headline earnings growth remained under control with a decline to 4.0% in the year to October from 4.1%.

Wider inflation fears were still a significant factor with inflation expectations rising to a nine-year high while headline output producer prices inflation was also at a 5-year high, although the core data was more favourable with a 2.1% annual increase.

The CBI industrial survey indicated a gradual slowdown, although the orders index remained positive with no evidence of a severe deterioration

Libor interest rates eased after the central bank measures to boost liquidity, but remained at elevated levels as underlying stresses persisted.

Swiss franc:

The National Bank decision to leave interest rates on hold will tend to undermine the franc slightly in the short-term, but the impact will be limited by the potential for an increase in the first quarter of 2008. The franc moves will remain correlated strongly with levels of risk aversion and a sustained improvement in credit markets would tend to undermine the Swiss currency. Nevertheless, the franc should be able to resist heavy selling pressure.           
 
The Swiss currency lost ground against the Euro during the week as risk aversion eased and the franc also weakened steadily to lows beyond 1.1450 against the dollar.

The National Bank left interest rates unchanged at 2.75% following the latest quarterly meeting, the first time rates had been left on hold for two years.

The bank upgraded its inflation forecast for 2008 slightly, although the bank expressed no urgency over the inflation situation. Bank chairman Roth also warned that the banking difficulties would have some negative economic impact

Demand for the Swiss currency was undermined by an overall recovery in risk appetite as equity markets attempted to secure gains.

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The Australian dollar pushed to highs around 0.8900 against the US dollar, but failed to sustain the gains and weakened back to around 0.8750 on Thursday with global growth doubts undermining the currency as erratic trading conditions persisted.

The Australian employment data was stronger than expected with a 52,600 increase for November, although there was an increase in unemployment to 4.5% from 4.3%.

The local currency strengthened temporarily as global stock markets reacted positively to the central bank plans to increase liquidity in global markets.

Volatility is liable to remain at elevated levels in the short-term, especially as liquidity issues will be important surrounding the year-end period. Domestic and international growth doubts will continue to restrict the potential for currency gains.

Canadian dollar:

The Canadian dollar was unable to strengthen through the 1.00 level against the US currency and weakened to lows beyond 1.02 on Thursday as the US dollar rallied.

Following the firm employment data at the end of last week, there were no major domestic data releases. There was a slight recovery in housing starts and a marginal recovery in October manufacturing shipments after a sharp drop the previous month.

The trade surplus recovered to CAD3.3bn from CAD2.8bn previously. The Canadian dollar, however, was undermined by a drop in industrial commodity prices.

Bank of Canada Governor Dodge expressed relief that the Canadian dollar had weakened back to more acceptable ranges while there were no clear hints on the timing of any further interest rate cuts.

The Canadian dollar is liable to drift weaker in the short-term, especially as competitiveness issues will persist, although sharp losses should be avoided.

Indian rupee:

The rupee was again confined to relatively narrow ranges as there were no clear pressures on the currency. Overall, the rupee edged slightly stronger to around 39.40 against the US currency before settling close to this level on Friday.

There were modest net inflows into the local stock market during the week which provided some degree of rupee support.

The local currency was contained by a generally firmer US dollar tone while credit fears sparked a temporary decline in the stock market. Fears over central bank intervention to stem rupee gains stifled short-term demand for the currency.

The rupee will gain support if risk aversion eases on a sustained basis, With the central bank opposing any rapid gains, the rupee is liable to stall near current levels.    

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The Hong Kong dollar had a marginally weaker tone and briefly touched the central parity rate of 7.80 against the dollar before recovering back to 7.7970 on Friday.

The local currency was unsettled by lower money-market rates due to a reduction in forthcoming share offerings. One-week interest rates fell to lows near 2.80%.

The US Federal Reserve interest rate cut provided some Hong Kong currency support.

The Hong Kong dollar should be able to find further near-term support close to 7.80 against the US dollar even with lower money-market rates limited the immediate prospect for local currency gains.

Chinese yuan:

The Chinese yuan continued to advance over the week, although gains slowed over the second half due in part to a wider US currency rally. The local currency strengthened to fresh post-revaluation highs near 7.36 against the dollar on Thursday before weakening to 7.37 on Friday with the NDF market remaining strong.

The domestic data was yuan supportive with a US$26.3bn trade surplus for November while the annual inflation rate increased to 6.9% for the month which was an 11-year high for the main inflation reading.

There were no substantive announcements following the Sino-US trade talks with US officials not suggesting that China had changed currency policy. There were, however, hints from government officials that the Chinese currency would be allowed to strengthen at a faster pace over the next few months.

A wider daily fluctuation band or one-off revaluation remains a realistic policy option given the underlying inflation pressures. A tolerance of gradual yuan gains remains the more likely short-term policy option for the central bank.