Weekly Forex Currency Review 18-01-2008

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Overall strategy: Global risk aversion is likely to remain at elevated levels which will provide further underlying support to low-yield currencies such as the yen and Swiss franc, although market volatility will remain high. Fears over a wider downturn in the global economy should offer important protection to the US currency even with US recession fears.                    

Key events for the forthcoming week

Date Time (GMT) Data release/event
Tuesday January 22nd 14.00 Bank of Canada interest rate decision
Wednesday January 23rd 09.30  Bank of England MPC minutes

Dollar:

There will be persistent fears that the US will enter recession or is already in recession conditions, especially with consumer spending liable to weaken. There will be further pressure on the Federal Reserve to cut interest rates aggressively to support the economy.

 The evidence suggests that there will be a sizeable rate cut at the end of January which will reinforce the lack of yield support. The dollar will continue to gain some important support from increased doubts over the global economy and the potential fiscal stimulus. Overall, the US dollar will remain vulnerable, although it should be able to avoid heavy selling pressure.   
      
The dollar weakened to lows beyond 1.49 against the Euro before a rapid correction to near 1.46 as short positions were squeezed. The US currency was unable to secure more than a limited rally on a trade-weighted basis in choppy trading conditions.

US retail sales fell 0.4% in December with underlying sales also falling by 0.4%, although this followed a strong report for November. The Philadelphia Fed survey fell sharply to -20.9 for January while the New York survey was little changed.

Headline consumer prices were slightly above expectations at 0.3% while core prices rose 0.2% to give a 2.4% annual increase. Core producer prices also rose 0.2% over the month with the headline 2007 PPI increase at a 25-year high.

Although the November trade deficit increased, long-term capital inflows remained firm at US$90.9bn for the month.

The Fed's Beige Book reported that growth had moderated while housing-sector difficulties persisted and consumer spending was subdued. The report also indicated that the labour market as still tight.

Unease over the US financial sector was fuelled by additional debt write-downs by the major investment banks and weaker quarterly results. The sharp Wall Street drop provided some net dollar protection against European currencies on defensive demand

Markets continued to price in an aggressive Fed policy stance with some speculation that rates would be cut before the scheduled January 30 FOMC meeting. President Bush announced a US$150bn temporary fiscal stimulus plan.

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There will be further uncertainty over ECB policy in the short-term with markets not convinced that the bank's tough rhetoric will be consistent with the economic developments. There will be expectations of a significant slowdown in the economy and there will be particular fears over economies such as Italy and Spain, especially if property prices fall sharply. Weaker financial markets will also tend to undermine the currency. The Euro will struggle to gain strong support in these circumstances, although heavy losses are unlikely.      

The Euro had a generally softer tome over the week, As well as a retreat against the dollar, the Euro lost ground against Sterling, the yen and Swiss franc. The increase in global risk aversion acted as a net negative factor the currency.

The German ZEW index weakened further in January with a 15-year low of -41.6 for the main index while the institute's growth forecasts were also lowered.

There were mixed comments from ECB officials with indications of greater concern over the Euro-zone economy by Mersch apparently rebutted the following day. There was still greater caution over the Euro-zone economy as a whole with expectations that growth forecasts would be downgraded.

The final December Euro-zone consumer inflation rate was confirmed at 3.1% with a 1.9% core rate which maintained unease over price trends.

Yen:  

There will be further unease over the Japanese economic trends, especially as the Bank of Japan has downgraded its assessment of the economy, and the yield structure will remain negative for the yen. Global risk trends will tend to remain dominant in the short-term and the yen will gain important support from fears over a global economic deterioration. The yen will also gain strength if there is a further slide in stock markets or credit contraction fears. The yen will correct sharply weaker at time, although the overall trend should be for net gains.     
                    
The yen advanced strongly over the first half of the week, strengthening to a 30-month high against the US dollar close to 106.0, and securing a convincing break of 160.0 against the Euro. These was some retracement over the second half of the week as risk appetite attempted to recover.

The Bank of Japan downgraded its assessment of economic conditions and warned that there were increased risks to the economic outlook from sub-prime related difficulties with a greater impact on the banking sector.

Consumer confidence fell to a five-year low, but there was an increase in wholesale prices inflation while the core machinery orders data was stronger than expected despite a monthly decline.

There was some evidence of capital repatriation back to Japan as the Nikkei index weakened to below the 14,000 level.

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Confidence in the UK economy will remain weak in the short-term with further unease over the consumer and property sectors. There will be strong expectations that the Bank of England will cut interest rates in February, although expectations of a series of cuts during 2008 could ease slightly given the bank's inflation concerns. The fears over US and European growth trends will offer some protection for the UK currency and there may be scope for a further correction after recent heavy losses. Sterling will struggle to make much headway and will be vulnerable to renewed selling pressure later in 2008.   
 
Sterling remained under heavy selling pressure early in the week with fresh record lows beyond 0.76 against the Euro and a test of support near 1.95 against the dollar. Sterling then managed a corrective recovery as the UK currency was heavily over-sold after recent losses with a move back towards 0.74 against the Euro.

UK consumer prices rose 0.6% in December with the annual inflation rate remaining at 2.1% for the third successive month despite upward pressure from food prices. The core inflation rate also held steady at 1.4% for the month. The annual increase in producer prices was at a 16-year high.

The annual rate of average earnings growth was steady at 4.0% in November while there was a further decline in the claimant count of 6,400 for the month.

The RICS index of house price trends fell to -49.1 in December from -40.6 previously and this was the weakest headline figure for 15 years. Retail sales volumes fell 0.4% in December which cut the annual increase to 2.7%

Bank of England Deputy Governor Gieve stated that the case for lower interest rates had been boosted by the global credit crunch which could cause a deep and painful slowdown. He also warned that inflation was likely to rise over the next few months.
 
Swiss franc:

The domestic data will continue to be monitored in the short-term and evidence of a slowdown triggered by adverse credit conditions would tend to undermine Swiss franc sentiment. Currency moves, however, are liable to be dominated by degrees of risk aversion in international markets. Fears that the global credit crunch will damage growth and stock markets should lead to further short-term demand for the Swiss currency. The overall trend should also be firm despite intermittent retreats when there is a recovery in stock markets.             
 
The franc strengthened to new all-time highs against the dollar close to 1.0850 before weakening back towards 1.10 later in the week as a technical correction set in. The franc remained strong against the Euro, but failed to hold the best levels.

The Swiss currency continued to gain support from the increase in risk aversion over the first half of the week as global stock markets remained under pressure. There was some easing of risk conditions over the second half of the week.

There were no major data releases over the week, but the ZEW expectations index continued to weaken to the lowest level for over 12 months.

National Bank member Jordan stated that the Swiss economy would be affected by the global credit crunch, although there were no direct references to monetary policy

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The Hong Kong dollar pushed to a five-week high of around 7.7940 against the US currency during the week before drifting back towards 7.80 and then weakening further to 7.8070 on Friday.

The drop in US yields curbed arbitrage activity and provided some significant initial support to the Hong Kong dollar. The local currency failed to hold the gains as a drop in the Hang Seng index undermined confidence with a retreat to 7.8070 on Friday.

The domestic data remained strong with unemployment falling to 3.4% in the latest 3-month period from 3.6% previously. HKMA chief Yam stated that the strong rise in money supply was not a significant problem

Overall, the Hong Kong dollar will find it difficult to extend gains much beyond the 7.80 level against the US dollar.

Chinese yuan:

The Chinese yuan weakened in the middle of the week, although this was primarily a technical move rather than a shift in underlying trend. The yuan settled around 7.25 against the US dollar which was still a net gain for the week.

The Chinese central bank again increased reserve requirements in the latest week and this triggered an increase in demand for dollars to meet the new requirements. The central bank still guided the Chinese currency stronger over the week

There was persistent speculation that further monetary tightening would be required and underlying yuan demand remained strong.

The underlying fundamentals will continue to promote yuan appreciation, especially as inflation fears will persist. Doubts over global economic trends are liable to slow yuan gains, although longer-term appreciation remains realistic.