Weekly Forex Currency Review 19-10-2007

Overall strategy

Dollar confidence will very remain fragile in the short-term with continuing speculation that economic weakness will force further Federal Reserve interest rate cuts. The extent of G7 tolerances for dollar weakness and the degree of pressure for Asian currency appreciation will be very important in determining near-term currency trends with markets looking to test G7 resolve. Sterling is likely to remain vulnerable in the medium term.         

Key events for the forthcoming week

Dollar

The very weak housing data will reinforce fears over a wider deterioration in the economy and maintain pressure for the Federal Reserve to sanction a further cut in interest rates. There will also be persistent medium-term concerns over the threat of reserve diversification away from the US currency. The Fed stance will be very important for dollar confidence as market perceptions of dollar neglect would sharply increase potential selling pressure. There is likely to be some verbal intervention to support the US currency, but more definitive action is still unlikely at this stage which would undermine the currency. This will limit scope for dollar recoveries despite some support on valuation grounds.
      
The dollar failed to sustain rally attempts during the past seven days and weakened to record lows beyond 1.43 against the Euro. The US currency also fell to new 30-year lows against the trade-weighted index before finding some support on Friday.

The US housing data remained very weak with starts dropping by a further 10.2% in September to give an annual rate of 1.19mn which was the lowest level for 14 years. Permits also fell further to an annual rate of 1.22mn.

Consumer prices rose 0.3% in September due to a rebound in energy prices while there was a 0.2% increase in core prices to give a 2.1% annual increase.

Industrial production rose by a marginal 0.1% for the month while the Philadelphia Fed index dropped to 6.8 from 10.9, although the prices index was strong.

The Fed's Beige Book reported that growth decelerated in September and early October with notable weakness in housing, although the labour market was still tight.

Markets pushed the chances of an October interest rate cut back to above 50% following the housing data and weak Bank of America results.

There was a strong reading for the New York manufacturing index. Jobless claims rose to 337,000 in the latest week from 309,000.

There were reported net long-term capital outflows of US$69.3bn for August while there were total net outflows of US$163bn, the weakest figure for close to 10 years. There was also net selling of US Treasuries by Asian central banks.

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There will be further expectations of a slowdown in the Euro-zone economy. The performance in relation to other G7 economies should remain firm in the short-term and the ECB is still looking to maintain a tightening bias on interest rates. Without strong action to curb the currency, the Euro is likely to retain  a solid tone, although it will be difficult to secure substantial gains from current levels. A sustained increase in risk aversion would tend to undermine the currency.              

The Euro retained a generally strong tone over the week even though there were varying performances. The Euro was unable to hold its best levels against the yen and Swiss franc as risk aversion increased again.

The German ZEW economic sentiment index held steady at -18.1 for October

German officials remained generally optimistic over the economy's direction. The German economic institutes downgraded their 2008 growth forecasts for the German economy, but were also generally confident over the situation.

ECB officials took a generally firm tone on monetary policy during the week.

Yen  

Without Bank of Japan action to increase interest rates, the yen will remain vulnerable on yield grounds. There will also be further retail interest in selling the yen. The volatility this week and a renewed surge in risk aversion will tend to increase caution over carry trades which will protect the currency. Expectations over underlying Asian currency appreciation will also help support the yen. More intense pressure for a stronger yuan from G7 members would also tend to strengthen the Japanese currency. In the near term, advances much beyond current levels are likely to be met with selling pressure.                    
                    
The yen found support towards 118.0 level against the dollar and strengthened back to 115.0 late in the week. The yen also regained ground against the Euro.

The yen moves were correlated strongly with global stock market moves. A downturn in Wall Street and renewed concerns over financial-market conditions boosted the yen as carry trades wee pared back.

The yen secured some support from speculation over a Chinese yuan revaluation.

The monthly Tankan index weakened to a two-year low according to the October data. The services-sector activity index was firmer for the month.

The yen was still contained by evidence of retail selling when the yen ground, but there was some evidence of increased institutional yen support.

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The latest data has eased immediate fears over a sharp deterioration in the economy which will underpin Sterling. There is still evidence of an underlying slowdown and there are high risks associated with the housing sector, particularly given the extreme debt levels. The Bank of England will be cautious over policy in the short-term, but the overall economic risks suggest that rates will be cut within the next few months. The capital account is also liable to be weaker on negative merger-related flows which will tend to weaken Sterling.                    
 
Sterling has been unable to challenge levels beyond 0.6950 against the Euro during the week, dipping back towards 0.70. The UK currency pushed to highs around 2.05 against the dollar as the US currency stumbled before hitting fresh selling pressure.

Headline consumer inflation was unchanged at 1.8% for September. The core rate fell to 1.5% form 1.8% the previous month which was the lowest for 11 months

Retail sales rose by 0.6% in September after a revised 0.7% increase the previous month to give a 3-year high for annual growth, although the volume gains were again achieved through lower prices

The labour-market data was firm with a 12,800 drop in unemployment while average earnings growth rose back to 3.7%. Advance third-quarter GDP was reported at 0.8% to give 3.3% annual growth as retail spending held firm.

The Bank of England minutes from October's MPC meeting recorded a 8-1 vote for unchanged rates with Blanchflower dissenting and calling for an immediate rate cut.

There was further Euro buying to fund the RBS-led takeover of ABN Amro.

Swiss franc

The Swiss franc will be vulnerable to selling pressure when risk tolerances are generally high. The National Bank warnings over interest rates and protests against currency weakness will deter short-term selling pressure on the currency and the fundamentals will remain robust. The franc will also gain support if there is a sustained increase in risk aversion. Serious strains on Eastern European currency pegs could trigger sharp gains for the Swiss currency.       
 
The Swiss franc weakened to lows around 1.68 against the Euro before recovering significantly over the second half of the week. The dollar was unable to sustain gains above 1.18 against the franc and dipped to 1.1660.

National Bank President Roth stated that it was wrong to assume that there won't be any further interest rate increases. Roth also stated that the bank would remain particularly vigilant over inflation and that franc weakness was not justified

The trade surplus rose to CHF1.8bn in September as export growth remained robust.

The franc drew some support from renewed losses in global equity markets and a spike in credit-related fears after poor Bank of America results.

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The Australian dollar pushed to highs above 0.9050 against the US dollar before dipping sharply to 0.8820 as credit-related fears increased again.

A renewed increase in risk aversion triggered a reduction in Australian dollar buying from Japanese investors

Commodity prices held generally firm and this provided Australian dollar support

There was little in the way of domestic data. The announcement of November Federal elections dampened speculation over an interest rate increase next month.

Despite strong yield support, the Australian dollar will be vulnerable to a deeper correction if risk aversion remains at elevated levels.

Canadian dollar

The Canadian dollar resisted pressure for a correction against the US currency, but was unable to make much headway and weakened against the Euro.

The Bank of Canada left interest rates on hold at 4.50% following the latest monetary policy meeting.

The bank's statement had a very slight easing bias as concerns over a tightening of domestic conditions was offset by concerns over currency strength. The monetary policy report confirmed expectations of stable interest rates in the short-term.

The Canadian dollar drew significant support from record oil prices, although there were also fears over a slowdown in growth which curbed the beneficial impact.

There will still be pressure for an underlying correction weaker after recent rapid gains, especially if credit-related fears return.

Indian rupee

The rupee was generally strong early in the week, but volatility then increased sharply. The stock market regulator proposed that there should be curbs on foreign investment which triggered a very sharp correction in the stock market. There was also a sharp retreat in the rupee to near 40.0 against the dollar.

The rupee regained composure late in the week as the stock market attempted to stabilise. The rupee was close to 39.80 on Friday with the currency hampered by underlying global risk aversion.

The importance of capital account trends was illustrated by net inflows of around US$4.6bn for October and any reversal would weaken the rupee sharply. The rupee gained some support from general strength in Asian currencies.

Rupee volatility levels are liable to remain higher in the short-term with the risk of a further correction weaker even if underlying confidence remains firm. 

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The Hong Kong dollar has remained strong during the past week. The local currency strengthened to a new 17-month highs close to 7.75  against the US currency which is the stronger limit of the existing band.

There was further expectations of capital inflows which supported the Hong Kong dollar. Money-market interest rates also remained high which provided important backing for the currency.

The HKMA is obliged to intervene and sell the local currency to protect the band if the 7.75 level against the dollar is breached.

Rumours that the Chinese authorities could allow arbitrage activity between stocks listed in Chin and Hong Kong increased volatility and boosted Hong Kong stocks.

The Hong Kong dollar should remain firm in the short-term on capital inflows, but there will need to be a realignment of the currency band to allow further gains.

Chinese yuan

The Chinese yuan held weaker than the 7.50 level against the US dollar with gains blocked by the central bank. The yuan was near 7.5080 against the dollar with China at this stage resisting international pressure for a stronger currency.

The central bank did suggest that market forces would be given a greater role in setting the currency's level.

NDF markets priced in more aggressive yuan appreciation over the next six months on speculation that the authorities would allow faster appreciation. Domestic players were more cautious over the prospects for yuan gains.

The consumer inflation rate eased to 6.2% in September from 6.5% in August. The central bank warned that further monetary tightening would be required to curb overheating in the economy

There will be further underlying pressure for a stronger yuan. The most likely outcome is a slow advance, although there is certainly a chance of a revaluation.