Weekly Forex Currency Review 18-05-2007

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Overall strategy

The dollar has the potential for a further modest correction from recent lows due to slightly increased confidence over US economic conditions. The housing difficulties are likely to limit the potential for US currency gains with fears over a prolonged downturn. There are still high risks associated with carry trades as it is unlikely that risk tolerances will stay at the current very high levels.

Key events for the forthcoming week

Dollar

The latest US economic evidence has been mixed, but with some evidence of a recovery in manufacturing and a solid labour market. Firm growth in other sectors of the economy would help cushion the impact of continuing stresses in the housing sector. The Federal Reserve would also be more comfortable with leaving interest rates on hold. Yield spreads have not moved strongly in the dollar's favour which will limit dollar gains, but there is the potential for short-term US currency sentiment to stabilise.   

The dollar weakened to lows just beyond the 1.36 level against the Euro before recovering back to 1.3480 on Thursday while the dollar overall secured gains on a trade-weighted index for the third week as Treasury bond yields increased.

US consumer prices rose 0.4% in April as gasoline prices rose while the core monthly increase of 0.2% cut the annual increase to 2.3% from 2.5% the previous month.

Housing starts rose to an annual rate of 1.53mn in April from 1.49mn the previous month, but there was a sharp drop in permits to the lowest level for close to 7 years which dampened confidence in a sustained recovery.

The New York manufacturing index rose to 8.0 in May from 3.8 the previous month. The Philadelphia Fed survey also strengthened to 4.2 for the month from 0.2 previously with solid increases in the employment and orders components.

The latest capital account data recorded long-term inflows US$67.6bn from US$58.1bn the previous month, but markets were focussed on yield trends.

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Confidence in the Euro-zone economy will remain firm in the short-term with the ECB still on track for a June interest rate increase. There will be some concerns over the property sector and there are also increasing signs of stress in economies such as Spain. In this environment, confidence is liable to weaken slightly with a scaling back of more aggressive interest rate expectations. The Euro will struggle to secure further firm buying support given the tightening already priced in. 

The Euro held a generally firm tone with gains against high-yield currencies, although it encountered resistance at higher levels against the dollar

The Euro-zone growth data remained generally firm with first-quarter GDP growth of 0.6% which gave an annual increase of 3.1%.

The ECB retained a tough stance in the latest monthly report with comments from officials continuing to suggest an interest rate increase to 4.0% will be sanctioned at the June meeting.

There was evidence of some underlying stresses in the Euro-zone property sector.

Yen  

The economic data has not supported the case for a further near-term increase in interest rates. This will tend to undermine the yen in the short-term with further interest in buying high-yield currencies. The Bank of Japan will still consider an early increase in rates and there is the growing risk of instability surrounding carry trades. There will also be underlying pressure for Asian currency appreciation to ease trade imbalances which should cap yen losses.     
                    
The yen weakened to record lows against the Euro during the week and also fell to a 3-month low against the dollar at 121.30.

Japanese GDP growth was held to 0.6% for the first quarter of 2007 as firm gains for domestic spending and exports was offset by a drop in capital investment.

In this context, there was also a 4.5% drop in machinery orders for March which undermined confidence in the industrial sector.

The Bank of Japan left interest rates on hold at 0.5% following the latest policy meeting and also left its assessment of the economy unchanged. Bank Governor Fukui stated that the bank could still increase interest rates even if consumer prices were falling.

The latest capital account data continued to record strong outflows from Japan, although there was also an increase in inflows with the net position close to balance.

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Following the Bank of England inflation report, there will be expectations of a further interest rate increase within the next 2-3 months which will support Sterling. The UK currency has, however, already discounted a substantial amount of favourable news and will be vulnerable to heavy selling pressure if the housing sector falters. Overall investment flows are also liable to be weaker and Sterling is liable to depreciate gradually over the next few weeks as a whole.   
 
Sterling weakened to two-month lows against the Euro around 0.6855 and also gradually retreated to lows below 1.9750 against the dollar as the US currency rallied.

Consumer prices rose 0.3% in April which cut the annual inflation rate to 2.8% from 3.1% the previous month. The core rate fell to 1.8% from 1.9% while the RPI rate dropped to 4.5% from 4.8%.

There was a further drop in unemployment claims for the month while headline earnings growth fell to 4.5% from 4.6% previously with underlying earnings growth rising to 3.7% from 3.6%. Retail sales fell 0.1% in April.

The Bank of England inflation report took a balanced view on growth and expressed major uncertainty over prospects, but stated that the medium-term inflation risks were on the upside. The comments suggested that the Bank expects to increase interest rates again over the next few months.

Swiss franc

The low level of nominal interest rates will maintain the temptation to sell the franc. The Swiss fundamentals will remain strong, however, and the National Bank will increase interest rates again in June. The Bank is also uneasy over current franc weakness and may consider a 0.5% interest arte increase to stabilise inflation and currency expectations. The Swiss currency will also gain rapidly if there is a disorderly unwinding of carry trades. Overall, the Swiss currency should regain ground over the remainder of the second quarter.  
 
Despite intermittent rallies, the Swiss franc remained on the defensive against the Euro with a test of support levels beyond 1.6550. The currency also weakened to lows beyond 1.2270 against the dollar.

The Swiss economic data remained strong with a 7.6% increase in retail sales in the year to March.

The National Bank again warned over franc weakness with further comments that the currency had moved away from fundamentals. There was no evidence of intervention to support the franc.

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The Australian dollar hit selling pressure close to 0.8350 against the US dollar and weakened back to lows near 0.82 before a tentative recovery.

The Australian domestic data failed to have a strong impact with a subdued increase for wholesale prices while there was a solid increase for average weekly earnings.

The Australian currency was undermined by a drop in commodity prices as copper prices fell sharply over the week.

The Australian dollar will be vulnerable to further selling pressure if there is evidence of a downturn in global growth, although heavy selling should be avoided.

Canadian dollar

The Canadian again performed strongly over the week with a further challenge on levels stronger than 1.10, an 11-month high for the local currency. The currency performed well despite the weaker than expected employment data at the end of last week with a high close to 1.0950 on Friday.

The Canadian inflation data recorded an increase in prices of 0.4% for April while core prices rose 0.2% which pushed the annual core rate to the highest level since 2003 at 2.5%.

There was a strong increase in manufacturing shipments of 2.8% for the month, maintaining generally strong growth trends.

The overall growth trends are likely to underpin the Canadian dollar, but the currency will struggle to extend gains after the recent rapid advance.

Indian rupee

The rupee has remained generally firm over the week, although there has been increased evidence of two-way trade with the currency close to 40.85 against the dollar on Friday. There was a recovery in local overnight interest rates to around 9.0% which helped sustain short-term rupee demand.

There was caution over intervention by the Reserve Bank, although dollar buying by the bank appeared limited. There was further dollar demand from oil refiners during the week and this curbed the potential for rupee buying.

Overall rupee confidence will remain firm on confidence over capital inflows, but the currency is still vulnerable to a more substantial correction weaker.

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The Hong Kong dollar was more volatile during the week and failed to sustain gains.

The Chinese regulation changes to allow increased investment in overseas stocks supported the Hong Kong stock market and the local currency with significant Hong Kong dollar gains to 7.8130 after the announcement.

The Hong Kong dollar gains were limited by generally firmer US economic data over the week. A combination of firmer US data and a dip in local stocks on fears over further Chinese monetary tightening pushed the currency to 7.8220 on Friday.

The Hong Kong dollar should find support close to 7.8250, but with only limited gains realistic given continuing arbitrage activity.

Chinese yuan

The Chinese yuan has remained strong with further gains to post-revaluation highs during the week. The currency strengthened to near 7.67 on Friday even though the US dollar was generally firmer.

The changes to investment rules designed to promote capital outflows failed to have a major yuan impact given the size of underlying capital inflows.

There was yuan support ahead of US-China trade talks next week with speculation that the Chinese authorities would sanction a faster rate of yuan appreciation.

Yen weakness against the dollar restrained the Chinese currency to some extent.

Underlying pressure for Chinese yuan appreciation will persist. The pace of yuan gains is still likely to be slow as the authorities resist faster gains, although some acceleration is certainly realistic.