Weekly Forex Currency Review 21-09-2007

Overall strategy

The dollar will remain vulnerable in the short-term, especially with speculation that the Fed will continue to cut interest rates. Given the amount of economic deterioration priced in and the potential damage to the European economy, the US currency should be able to avoid further sharp losses against the European currencies even with very weak near-term confidence.       

Key events for the forthcoming week

The dollar will remain vulnerable to further downward pressure in the short-term with persistent fears over a slide into recession while speculation over further Federal Reserve interest rate cuts will also tend to undermine the currency. There will also be concerns over the medium-term threat of reserve diversification into other major currencies. The dollar has, however, discounted a substantial amount of bad news and will gain some support if the wider economy appears to be holding firm. Even with the threat of further short-term losses, a significant correction should be achievable within the next few weeks.
      
The dollar remained under pressure during the week with record lows beyond 1.41 against the Euro following a break of 1.40. The US currency also dropped to fresh 15-year lows on a trade-weighted basis.

The Federal Reserve cut benchmark interest rates by 0.50% following the latest FOMC meeting with the Fed funds rate cut to 4.75%, the first cut for four years.

In its statement, the Fed stated that it had cut rates to forestall damage to the wider economy from housing-sector weakness. Fed Chairman Bernanke warned that sub-prime mortgage delinquencies would continue to increase in the short-term.

The housing data remained weak with housing starts falling to an annual rate of 1.33mn while permits fell to 1.31mn and both figures were at 15-year lows.

Consumer prices fell 0.1% in August as energy prices fell. There was an underlying 0.2% increase to give an annual increase of 2.1% from 2.2% the previous month.

The latest capital account data recorded a sharp drop in long-term capital flows to below US$20bn in July from US$97.3bn the previous month as corporate bond inflows weakened. There was a strong increase in shorter-term inflows.

The dollar was undermined by fears over central bank reserve diversification following rumours that Saudi Arabia would drop its peg to the US currency.

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The ECB is likely to maintain a firm policy stance in the short-term which will help underpin the Euro. There will still be reduced expectations of further increases in interest rates and concerns over the economy are liable to increase, especially surrounding Spain. There will also be the threat of more forceful protests against Euro strength from finance officials with policy tensions between governments and the ECB. The Euro should still be able to hold firm in the short-term with intervention speculation curbing buying support.            

The Euro secured a strong tone over the week as whole with 18-month highs against Sterling as well as record highs against the dollar. The Euro was unable to sustain the best levels against the yen and Swiss franc.

The German ZEW business confidence index fell to -18.1 in September from -6.9 the previous month which pushed the index close to record lows. The Euro-zone PMI manufacturing index weakened to 53.2 in September from 54.3 the previous month.

There were further concerns over the Spanish economy during the week despite persistent official denials of difficulties in the banking sector.

The ECB took a generally firm stance on monetary policy during the week, although markets generally downgraded expectations of further interest rate increases.

French President Sarkozy called on the ECB to cut interest rates, but protests against Euro strength were relatively mild at this stage.

Yen 

The Bank of Japan's reluctance to increase interest rates will maintain a lack of yield support for the yen. There is also likely to be unease over potential weakness in key Japanese business surveys, especially with US growth fears. There has been further interest in allocating investment funds overseas, but confidence is liable to remain fragile and the yen has been able to avoid strong selling despite the latest Wall Street rally. The underlying Chinese tightening will still provide important support for the Japanese currency and limit the scope for dollar advances with volatility likely to remain at elevated levels.                  
                    
The Japanese yen found support beyond the 116.0 level and strengthened to highs around 114.0. The yen weakened sharply against the Euro following the Federal Reserve's interest rate cut before stabilising.

The Bank of Japan left interest rates at 0.50% at the latest council meeting. There was an 8-1 vote for an unchanged policy with Mizuno voting for a rate increase. Bank Governor Fukui again failed to provide any clear guidance on future policy.

The monthly Tankan index of confidence was weaker than expected which reinforced concerns over the quarterly survey due for release at the beginning of October.

The latest capital account data recorded net inflows into Japan due to investor caution.

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There is likely to be further concerns that elevated debt levels and tighter credit markets will trigger a significant deterioration in the economy. Interest rate expectations are liable to be scaled back further in the short-term with increased speculation over a Bank of England cut before the end of 2007. The shift in expectations that has already taken place will lessen the risk of aggressive Sterling selling and the UK currency will also gain support on any sustained improvement in risk tolerances. The net trend is still likely to be for further underlying Sterling depreciation.               
 
Sterling came under consistent selling pressure against the Euro with 18-month lows beyond 0.70. There was high volatility against the dollar with the UK currency finding support below the 2.00 level.

Financial-sector stresses increased sharply early in the week as there was a sharp withdrawal of deposits from Northern Rock before a government guarantee eased immediate fears, although confidence was fragile.

The Bank of England faced criticism over a policy reversal as it announced plans to inject extra liquidity into money markets to help stabilise credit conditions.

The Monetary Policy Committee (MPC) minutes from the September meeting reported a 9-0 vote for unchanged rates while there were reduced inflation concerns.

Headline consumer inflation edged down to 1.8% in August from 1.9% while the core rate was also at 1.8%, but the Retail Prices Index rose back to above the 4.0% level.

The latest retail sales data recorded a 0.6% August increase in volumes as discounting again boosted sales with prices lower. The CBI industrial survey indicated that conditions were broadly stable.

Swiss franc

The National Bank hinted that interest rates may not be increased again in December, which will dampen franc support to some extent, although the decision will certainly remain open. The underlying Swiss fundamentals will also remain robust. Any sustained recovery in risk appetite would undermine the Swiss currency. Nevertheless, there appears to be growing risks of complacency over the credit situation. The net global risks indicate that the currency should be generally firm despite a possible near-term dollar base against the franc.    
 
Dollar support close to 1.18 against the franc was tested several times before the franc broke through this level. The US currency weakened to the lowest levels since the second quarter of 2005 below 1.17 before a fragile correction.

The annual producer prices inflation rate rose to 2.7% in August and the National Bank again warned over potential inflation risks from a weak currency.

The central bank hinted that interest rates may not be increased again in December, although it also indicated that policy options would be kept open.

Retail sales and business confidence were weaker in the latest data releases. The Swiss trade surplus narrowed to CHF0.64bn in August from CHF1.53bn the previous month, but there was still annual export growth of 9.7%.

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The Australian dollar secured further gains over the week with highs close to 0.8700 over the second half of the week which represented an 8-week high for the currency.

Risk tolerances improved over the week with the US Federal Reserve interest rate cut spurring demand for high-yield currencies and substantial gains for the Australian dollar. The Reserve Bank Governor took a generally confident view over the domestic economy which underpinned the currency.

The US rate cut boosted the Australian dollar's yield appeal while strong gains for gold prices also helped support the Australian currency..

Australian yield support will continue in the short-term, but it will be difficult to extend the strong recovery from August's lows.

Canadian dollar

The Canadian currency continued to gain ground against the US dollar and pushed to test parity for the first time since 1976. There was no opposition to currency strength from domestic officials with a Friday peak close to 0.9950 as the 1.00 level broke.

The consumer prices data recorded a 0.3% drop in prices for August while underlying prices rose 0.1% to give a 2.2% annual increase. There was a strong reading for wholesale sales with a 2.0% monthly increase for July.

The local currency drew further support from high oil prices over the week while the strong rise in gold prices also provided important backing.

The Canadian dollar should remain firm in the short-term, but is due for a substantial correction weaker after rapid gains this month.

Indian rupee

The rupee strengthened significantly over the week as the dollar came under pressure The Indian currency pushed to a 9-year high beyond the 40.0 level as the dollar came under wider selling pressure with highs around 39.85.

There were further flows into the local stock market following the US Federal Reserve interest rate cut which boosted rupee demand. The rupee yield spread over US dollar interest rates increased to the highest level for three years which also supported the currency.

There was evidence of central bank intervention to slow the currency's gains, although the bank was cautious over aggressive dollar buying.

Rupee confidence should remain firm in the short-term on optimism over capital inflows, but significant caution is required at current levels.

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The Hong Kong dollar has remained firm over the past week with gains to around 7.7840 against the US dollar.

The local currency was underpinned by a general lack of confidence in the US currency over the week There was further Hong Kong dollar demand associated with IPO offerings and higher inter-bank rates helped support the Hong Kong dollar.

There was some evidence of stock outflows from Hong Kong in the middle of the week which curbed currency gains. The HKMA cut the domestic base rate by 0.50% to 6.25% following the Federal Reserve interest rate cut

The Hong Kong dollar is likely to hit resistance close to the 7.78 level against the dollar as arbitrage-related US dollar buying will increase close to this level.

Chinese yuan

Wider selling pressure on the US currency helped push the Chinese currency to fresh post-float highs around 7.5050 against the dollar on Friday.

The yield gap rose to the widest level for three years during the week which provided background support to the yuan. This followed the 27 basis point interest rate increase announced at the end of last week

There was evidence of central bank resistance to further sharp currency gains with the bank looking to block any immediate gains through the 7.50 level.

The Chinese yuan was supported by general dollar weakness and by a firm tone for Asian currencies. There is likely to be further speculation over a revaluation

The net trend is still likely to be for a stronger Chinese yuan, especially with further pressure for a tighter monetary policy to curb domestic overheating. The central bank will continue to curb rapid currency gains, although a one-off revaluation should not be ruled out.