Weekly Forex Currency Review 15-06-2007

Overall strategy

Global interest rate considerations are likely to remain dominant in the short-term. Higher US yields and greater confidence in the economy should continue to underpin the US currency in the short-term. Overall volatility levels are liable to increase sharply over the next few weeks due to instability in capital flows. 

Key events for the forthcoming week

Dollar

The US data releases have continued to support increased market optimism over the US economy. Yield considerations will also continue to support the dollar with much reduced speculation over a cut in interest rates. Any move to price in a Fed tightening would tend to strengthen the currency further, but there will also be renewed fears over the housing sector which will curb enthusiasm for the US currency. There is also likely to be persistent central bank diversification way from the dollar on any strong rallies from current levels.       

The dollar retained a firer tone over the week and strengthened to two-year highs near 1.3260 against the Euro before consolidating close to 1.33.

US interest rate trends remained a very important feature with US 10-year bond yields rising to a 5-year high around 5.30% before a retreat back to 5.20% in volatile trading.

The retail sales data was stronger than expected with a 1.4% monthly increase for May while there was a 1.3% underlying increase. Although pushed higher by surge in gasoline sales, overall spending was still firm.

The Fed's Beige Book reported that overall growth was moderate, with further weakness in residential construction offset by a stronger commercial real-estate sector. Pricing pressures were considered generally modest in the survey, but producer prices rose 0.9% in the month as energy prices increased.

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There will be continuing expectations that the ECB will increase interest rates again during the second half of the year. These expectations will underpin the Euro, but some doubts over forthcoming growth data is liable to curb buying support, especially given the amount of tightening priced in already. There is also the threat of significant economic distress in countries such as Spain which would harm the Euro.     

The Euro drifted weaker against the dollar over the week, but was able to secure overall gains against low-yield currencies despite volatile trading. Consolidation was the dominant underlying Euro theme.

The ECB continued to take a firm stance on monetary policy. Bank President Trichet, for example, again hinted that further interest rate increases were likely with comments that policy was still accommodative at current levels.

The Euro-zone industrial data was generally weaker than expected with a significant monthly decline for April while May inflation was confirmed at 1.9%.

Yen 

The rise in global interest rates will reinforce the theoretical appeal of high-yield currencies and there is the potential for further capital flows from Japan with the yen vulnerable to initial selling. The Bank of Japan, however, is likely to increase interest rates in August which will help underpin the currency. There is also still a high risk of a dislocation in carry trades and a rapid yen correction stronger with volatility liable to increase.       
                    
The yen remained under pressure against the dollar during the week, falling to the lowest level since December 2002 at just beyond 123.20 while gains against the Euro were reversed.

The Japanese inflation indicators suggested a gradual increase in underlying inflation pressure as wholesale prices rose while first-quarter GDP was revised up to 0.8% from 0.6%.

The Bank of Japan left interest rates on hold at 0.50% following the latest policy meeting. The central bank also maintained its assessment of economic conditions with a commitment to gradual monetary tightening, but not a tough stance.

The latest capital account data suggested a small weekly surplus, but other evidence has continued to suggest a further outflow of funds from individual accounts. There were no major protests against yen weakness in the US semi-annual currency report.

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There will be continuing expectations of higher Bank of England interest rates. The most recent data, however, has suggested a moderation in consumer spending with some evidence of a slowdown in inflation and this evidence should reduce speculation over an increase in interest rates to the 6.0% level. Given the tightening priced in, the UK currency is liable to weaken over the next few weeks, although falls should be measured unless there is a sharp reversal in carry trades.     
 
Sterling had a firmer tone against the Euro over the past week, but failed to hold levels beyond 0.6750 and drifted weaker to levels around 1.97 against the dollar.

The headline consumer inflation rate fell to a 7-month low of 2.5% in May from 2.8% as food price inflation eased slightly. The underlying rate rose to 1.9% from 1.8% while retail price inflation eased slightly to 4.3% from 4.5%.

Headline average earnings growth fell to 4.0% in April from 4.5% with the underlying rate at 3.6% and surveys suggested some moderation in pressures.

Retail sales recorded a monthly increase of 0.4% to give an annual increase of 3.9% while prices were slightly lower. There were no major comments from Bank of England officials.

The data overall raised some market doubts that the Bank of England would increase interest rates to 6.0%.

Swiss franc

The National Bank is likely to continue the policy of monetary tightening with a further interest rate increase in September and a possible intra-meeting increase if inflation pressures intensify. The National Bank is also likely to continue the warnings over currency weakness. The franc trend will remain closely related to global carry trades and the overall level of yields will leave the franc vulnerable to short-term selling. There will be further market fluctuations, but the net risks suggest that the currency will appreciate in the medium term.
 
The Swiss currency weakened to lows around 1.2480 against the dollar during the week and also depreciated to 1.6580 against the Euro.

The National Bank increased interest rates by a further 0.25% to 2.50% following the latest council meeting while the bank also considered a 0.5% rate increase.

The central bank increased the 2007 inflation forecast to 0.8% from 0.5% and also increased the 2008 inflation forecast slightly.

There were further warnings that the planned monetary tightening through higher interest rates was being offset by the weaker Swiss franc which suggested that further action would be taken over the second half of 2007.

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The Australian dollar failed to hold gains above the 0.8440 level against the US dollar and weakened back towards 0.8350 in choppy trading as yield volatility persisted.

There were no major domestic data releases during the week with business and consumer confidence holding firm.

Reserve Bank Governor Stevens stated that inflation was likely to rise over the next few months, but he also stated that the bank had time to monitor the situation given that recent inflation data had been more favourable. Following the remarks, market expectations over another near-term increase in interest rates eased slightly.

The Australian dollar will be vulnerable to a further correction weaker as market volatility is liable to increase, especially if the New Zealand central bank intervenes in the market again.

Canadian dollar

The Canadian dollar was unable to sustain a move beyond 1.06 against the dollar and weakened to near 1.0750. The dominant theme was one of consolidation after recent strong gains with the US dollar unable to sustain levels above the 1.07 level.

There was little in the way of major Canadian economic data over the week with a decline in manufacturing shipments after a surge reported for last month. The Canadian currency fluctuated in line with movements in oil and wider commodity prices.

The Canadian dollar should retain a firm short-term tone on expectations of a July interest rate increase, although consolidation is still likely to dominate.

Indian rupee

The Indian rupee has fluctuated in choppy trading during the week as stock market volatility persisted. From lows around 41.25 at the end of last week, the rupee was unable to regain the 40.50 level and settled close to 40.95 on Friday.

There was initial strength in capital inflows associated with IPO offerings, but these flows eased later in the week Higher US yields helped support the US dollar against the rupee and there was further speculation over central bank intervention which restrained the currency.

The Indian economic data was firm with a 13.6% annual increase in industrial production for April, but fears over rupee over-valuation and deteriorating competitiveness persisted.

The rupee will should be able to resist heavy losses against the dollar unless there is a severe drop in regional stock markets with the central bank helping to cap gains near current levels.

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The Hong Kong dollar was trapped in relatively narrow 7.81 - 7.82 range against the dollar during the week and was close to 7.8175 on Friday. 

There was further arbitrage activity during the week as US yields remained higher. The increased yield spread over the Hong Kong dollar continued to encourage arbitrage selling.

The Hong Kong currency secured some support from a demand for funds and firmer interest rates ahead of forthcoming Chinese IPO offerings.

The Hong Kong dollar will find it very difficult to strengthen through 7.80 against the US dollar unless there are suggestions of a change in the currency regime with support coming in close to 7.82.

Chinese yuan

After the falls seen last week, the yuan regained ground and strengthened to a fresh post-revaluation high. From lows around 7.66, the Chinese currency strengthened to 7.624 against the US dollar this Friday, a post-revaluation high for the Chinese currency.

The central bank was again active in steering the yuan's exchange rate throughout the week.

China was not named as a currency manipulator in the US Treasury's semi-annual report, but the US continued to press for faster yuan gains and there was a US congressional bill to increase pressure on China for faster currency gains.

The Chinese data remained strong with a 73% annual surge in the May trade surplus to US$22.4bn while industrial production rose 18.1% over the year.

Officials will retain tight control of the exchange rate, but pressure for further currency gains will persist and the yuan should gain steadily over the next few weeks.