Weekly Forex Currency Review 16-02-2007

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Overall strategy:

The dollar will find it difficult to regain momentum in the short-term given structural and cyclical doubts over the economy, although selling pressure should be limited from current levels. There is the potential for a further, at least temporary, recovery in low-yield currencies as aggressive positions in high-yield currencies are scaled back.     

Key events for the forthcoming week

Dollar

The combination of subdued economic data and a slightly softer than expected testimony from Fed Chairman Bernanke will lessen dollar support in the short-term. The US currency will also be more vulnerable to structural concerns, especially in view of the weak capital inflows data this week. The existing yields should still offer important protection as speculation over a rate cut is liable to fade again. Overall, the US currency should be able to find support close to the 1.32 level against the Euro even with limited scope for near-term gains.

The dollar was unable to make a further challenge on 1.29 resistance against the Euro early in the week and a combination of growth and cyclical doubts pushed the US currency to lows around 1.3170 before a tentative recovery.

In congressional testimony, Fed Chairman Bernanke was optimistic over moderate growth in the economy and also stated that the pre-dominant risks were still tilted towards higher inflation. Bernanke, however, also stated that inflationary pressure was showing some signs of moderation which revived speculation that there would be scope for lower interest rates later this year. In the second part of the testimony, Bernanke took a slightly tougher stance on inflation.

The US retail sales data was steady for January, but there was a 0.5% drop in industrial production as manufacturing output deteriorated and capacity use fell over the month. The Philadelphia Fed index also weakened back to near zero in the February reading which dampened confidence.

The latest capital account data was significantly weaker than expected with long-term inflows dropping to US$15.6bn in December from a revised US$84.9bn in November while overall flows were negative. With the US trade deficit widening to US$61.2bn for December, there were some fresh concerns over US structural weaknesses.

The Euro-zone data has remained strong and markets will be expecting two ECB interest rate increases by the end of June which will offer near-term Euro support. Given the amount of tightening priced in, the Euro will be vulnerable to a sharp correction if forthcoming data suggests a deterioration in growth trends.  The overall fundamental strength should prevent heavy short-term selling pressure on the currency.

The Euro-zone data was generally strong over the week with the German GDP, for example, recording 0.9% growth for the fourth quarter compared with expectations of a 0.6% increase. The French and Italian GDP data was also strong which boosted confidence in the Euro-zone economy as a whole.

ECB officials continued to take a tough stance on monetary policy during the week, reinforcing their determination to control inflation. Markets remained very confident that there would be an interest rate increase in March and there was also increased speculation that the ECB would tighten policy again and push rates to 4.0% in June.

Yen  

Stronger growth data will lessen short-term yen selling pressure, especially as there will be increased speculation over a Bank of Japan interest rate increase next week. The underlying capital account has improved and there is likely to be a reduction in carry trades, especially with seasonal trends more favourable for the yen. Near-term dollar support is realistic in a 118.50-118.80 band, although there is a small possibility of a jump in risk aversion and rapid yen gains.
                    
The yen resisted losses through 122.0 against the dollar after the G7 meetings and the Japanese currency strengthened to highs around 119.15 later in the week.

There were no specific comments against yen weakness following the G7 meetings, but officials did warn over the need for caution over perceived one-way bets. This was a clear warning not to speculate even more aggressively against the Japanese yen and, despite market reservations, there was evidence of position adjustment.

The Japanese GDP data was stronger than expected with a 1.2% increase for the fourth quarter which gave an annualised rate of 4.8%. Significantly, there was a strong reading for consumer spending in the data which is a key Bank of Japan focus and market speculation over a February interest rate increase rose to over 50%.

The evidence still suggests that the Bank of England is expecting to raise interest rates again over the next 2-3 months to stem inflation. Markets have more than discounted one further increase which will make it difficult for Sterling to secure renewed buying support and, following the weak retain sales report, Sterling will be vulnerable to heavy selling of there is evidence of a housing downturn. Overall, the UK currency is liable to weaken on a trade-weighted basis. 

Sterling was generally weaker against the Euro during the week with losses to a one-month low around 0.6730 late in the week. Sterling was volatile against the dollar, but found support close to 1.94 as the US currency stumbled.

The major UK data releases was significantly away from market expectations over the week. The consumer inflation report recorded a drop in prices of 0.8% for the month which pushed the annual inflation rate down to 2.7% from 3.0% while the RPI rate dropped to 4.2% from 4.5% which eased inflation fears.

January retail sales were much lower than expected with a 1.8% drop, the weakest monthly report for 4 years as retailers resorted to discounting. Unemployment claims fell by 13,000 over the month while earnings growth edged weaker.

In its quarterly inflation report, the Bank of England stated that the inflation rate would decline sharply over the second half of 2007. The bank was still concerned over the potential for higher wage costs and expressed considerable uncertainty over the overall inflation outlook.

Swiss franc

The yield considerations will remain negative for the Swiss currency, especially with the strong Euro-zone data reinforcing expectations of a tough ECB stance. The Swiss fundamentals will remain strong and the franc’s defensive qualities are likely to be seen as more important if there is a sustained increase in risk aversion. Overall, the franc should find further support at levels weaker than 1.6250 against the Euro and 1.25 against the dollar. 
 
The Swiss currency weakened to lows around 1.6280 against the Euro before rebounding to 1.6220 while the franc strengthened to 1.2330 against the dollar.

There were no major Swiss data releases, although the retail sales data was strong. International trends remained dominant with global carry trades an important feature.

A yen recovery helped support the Swiss currency and there was some evidence of a switch into more defensive currencies as global structural economic fears re-surfaced.

The Australian dollar weakened sharply early in the week as the Reserve Bank lowered its 2007 inflation forecasts as the revised estimates suggested that a further interest rate increase was less likely.

There was strong support close to the 0.77 level against the US currency with a recovery to highs around 0.7865 late in the week as the US currency retreated.

There was little in the way of domestic data with a stronger reading for consumer confidence, but a drop in housing finance.

Commodity prices were also firm with copper and gold prices gaining over the week. Overall, the Australian dollar will struggle to secure further gains with capital inflows more restrained unless the central bank increases interest rates next week.
 
Canadian dollar

The Canadian dollar found support close to 1.1850 against the US currency and secured strong gains to near 1.16, supported in part by a weaker US dollar trend.

The Canadian economic data offered currency support with a higher than expected CAD5.0bn trade surplus for December while there was a bigger than expected increase in manufacturing shipments which boosted economic optimism.

The Canadian currency also benefited from a sharp drop in speculative positions against the currency as technical indicators turned more favourable.

The rupee hit tough resistance close to 44.05 at the end of last week and weakened to lows near 44.20 early this week as a drop in stock prices undermined sentiment.

Thereafter, the currency had a firmer tone as economic factors turned positive. There was a recovery in capital inflows while the central bank tightened monetary policy with an increase in cash reserve requirements.

The yen strengthened over the second half of the week and this also offered important support to the rupee which strengthened back towards the 44.05 level.

There was further evidence of central bank dollar buying to restrain the Indian currency during the week and markets were closed on Friday for a holiday.

The rupee should be able to retain a firm tone in the short-term, especially if the yen strengthens further, although a rise in risk aversion is likely to curb currency gains.

Hong Kong dollar

The Hong Kong dollar found support close to the 7.8150 level against the US currency and managed fragile gains during the week with gains to near 7.81.

There was a drop in US yields following Fed Chairman Bernanke’s congressional testimony and this provided significant Hong Kong dollar relief as arbitrage activity against the local currency declined.

The Asian currency gains also offered some support to the Hong Kong dollar. The currency is unlikely to secure strong gains in the short-term, although reduced confidence in the US currency should curb selling pressure. Trading activity will be subdued over the next week with new-year holidays on Monday and Tuesday.