Weekly Forex Currency Review 21-10-2011

Euro-zone developments will remain extremely important in the short-term with crucial EU and G20 Summits due over the next two weeks. If leaders fail to stem the underlying contagion risk and stabilise the banking sector, then fears over a global recession will intensify.  The principal feature is likely to be a sustained increase in volatility across all the major currencies, especially with banks looking to bolster balance sheets through capital repatriation.

Key events for the forthcoming week

Dollar:

There will be some continuing relief over the latest US data, especially if an improvement in the housing sector can be sustained, and recession fears are liable to ease slightly. The Federal Reserve will maintain an extremely loose monetary policy and there will still be speculation over further quantitative easing.  Global developments will remain extremely important in the short-term and there will be defensive dollar demand as banking-sector funding worries persist. Ironically, the US currency may lose ground if the US data improves as there will be reduced fears over a global downturn. Nevertheless, the dollar should retain a broadly firm tone in the very short-term.

The dollar was subjected to choppy trading conditions during the week as it attempted to regain ground following sharp losses the previous week, but the performance was never entirely convincing as support was fragile with limited trade-weighted gains.

The housing data was stronger than expected with a gain to 0.66mn for September from a revised 0.57mn previously and the NAHB housing index also strengthened.
The headline consumer prices index rise was in line with expectations at 0.3% while the core reading was slightly lower than expected at 0.1%.  The Fed’s beige Book generally reported that modest growth continued during September, although some districts were slightly more optimistic.

The New York manufacturing PMI index weakened again to -8.5 for October from -3.9 the previous month and this was the fifth successive figure below zero.  Jobless claims falling 6,000 to 403,000 in the latest week while there was a sharp recovery in the Philadelphia Fed index to 8.7 for October from -17.5 previously. Although existing home sales weakened slightly and the tone remained cautious, there were increased hopes that the economy could avoid recession.

There were further internal Federal Reserve stresses, but indications continued to suggest that policy would remain extremely loose over the next few months.

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There will be pressure to restructure the Greek bailout package, recapitalise the banking sector and strengthen the EFSF. There will be a high degree of political stresses, especially within Germany which will make Summit agreement difficult and increased debt write-offs for Greece will also be contentious. There will be strong pressure for a cut in ECB interest rates and there will also be fears that the ECB’s longer-term credibility will be damaged further with incoming president Draghi facing an extremely difficult task. The Euro could gain some degree of support from capital repatriation by Euro-zone banks and high volatility is likely to remain the principal feature.   

Euro volatility was a key feature during the week as there was strong buying support on retreats. There was a suspicion that European banks were repatriating capital which boosted the currency and it found support near 1.3650 against the dollar.

As far as the economy is concerned, the Bundesbank warned that the outlook had deteriorated further for the fourth quarter.  The latest German ZEW index weakened to a 34-month low of -48.3 from -43.3 the previous month and the Institute warned that Germany could already technically be in mild recession.

Italian bond yields continued to rise and approached the 6.0% level. Moody’s downgraded Spain’s credit rating for the third time sine June 2010. There were further uncertainties surrounding France’s AAA credit rating after it as put on review by Moody’s as French-German yield spreads widened to record highs.

Negotiations over the EFSF continued ahead of the planned Sunday EU Summit with a particular focus on disagreement between France and Germany. The French government still wants the EFSF to be made into a bank and for the ECB to play an increased role in providing guarantees and using its balance sheet to boost the fund. There is strong German opposition to this, not least because Chancellor Merkel would face strong opposition from within parliament.

France insisted that the Summit should go ahead rather than be postponed and, instead, there is likely to be a second meeting, probably on Wednesday 26th.  There was also still no agreement on increasing the ‘voluntary’ haircuts on private-sector Greek debt holdings with France resisting bigger adjustments due to the risks this would pose to the banking sector.

The troika report on Greece was finally published and the IMF concluded that the situation was more difficult than expected as a deeper recession put further downward pressure on tax revenues. The troika still recommended that the next loan tranche should go ahead as planned as Greece approved austerity measures.

Yen:   

There will be strong pressure on the Japanese government to alleviate stresses caused by a strong yen. There will also be pressure for the authorities to push the currency weaker. The yen will continue to gain important support from a lack of alternatives, especially with all the major currencies tarnished. There will also be potential capital repatriation from Europe. On a long-term valuation basis, there appears to be little scope for yen appreciation, but the currency could still prove to be resilient in the short-term.    

The dollar and yen were again trapped within narrow ranges during the week as breakout attempts failed. Risk conditions remained extremely important for the yen and there was fresh support for the Japanese currency when equity markets were subjected to fresh selling. There was some evidence of yen selling against the Swiss franc as there was an unwinding of long yen positions taken out against the franc.  

There was further speculation over potential repatriation flows from Europe which continued to limit the potential for yen selling. Finance officials confirmed that there would be a JPY2trn package of measures to help cope with the yen’s surge.

One of the key questions that needs answering is whether there will be attempts to cope with a very strong exchange rate by strengthening competitiveness or whether there will be active attempts to weaken the yen.

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There will be further concerns over the UK economy as underlying consumer spending is likely to remain under pressure even if headline retail sales hold steady. Real interest rates will remain extremely unattractive as the Bank of England continues to expand bond purchases.  The banking sector will be extremely important in the short-term and there will be further fears that additional bailouts will be required. There will also be the threat of capital withdrawals from the UK as Euro-zone banks increase capital ratios. In this context, Sterling could suddenly be subjected to heavy selling pressure.

Sterling was generally resilient during the week against both the dollar and Euro as the UK gained support from a position outside the Euro-zone.  

The consumer inflation data was stronger than expected with an increase in the headline rate to 5.2% from 4.5% previously. This equalled the highest rate seen over the past 20 years. Despite spiking briefly, Sterling was generally weaker following the data. Markets assumed that there would be no policy response from the Bank of England, especially as it is expecting the inflation rate to fall sharply in 2012.

The latest MPC monetary policy minutes recorded 9-0 votes both for the interest rate and the quantitative easing decisions. There was a marked change of tone as global and domestic economic fears increased. There had been some discussion whether to increase the bond buying of programme by GBP100bn rather than GBP75bn.

The latest retail sales data was stronger than expected with a 0.6% headline increase for September following a revised 0.4% decline the previous month. There were still fears surrounding the outlook, especially as the Nationwide consumer confidence index fell to near record lows of 45 for October.

The UK and Euro-zone banking sectors remained an important focus. There will be speculation that Euro-zone banks will pull funds out of the UK in order to bolster capital ratios and this would risk further serious damage to the UK economy.

Swiss franc:

The National Bank will remain determined to protect the minimum Euro level against the franc in the short-term and there will also be additional speculation that there could be a move to adjust the level weaker.  The latest price action still suggests that there will be some defensive franc demand at time if there is any increase in stresses surrounding the Euro-zone sovereign-debt crisis. The National Bank actions should still dominate in the short-term.

There was further speculation that there would be a change in the Euro minimum level against the franc, especially as there have been further domestic calls for the minimum level to be increased. Although the government stated that the franc was still very strong, there were no announcements at the weekly press conference while the National Bank made no comment.

In contrast to most of October, the moves later in the week were driven to a large extent by the Euro/Swiss cross. The Euro was subjected to significant selling pressure as it dipped sharply to lows below 1.2250. There were fresh fears surrounding the EU banking sector which provided some franc support. In this environment, the dollar was unable to hold above the 0.90 level.

The Swiss ZEW business confidence index improved to -54.4 for October from -75.7 the previous month which will ease fears over a very sharp downturn in the economy, although it will also maintain pressure for further franc gains to be resisted.

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The Australian dollar maintained a generally firmer tone over the first half of the week and found support in the 1.01 region against the US dollar, but it was unable to make a move above the 1.04 level. There was still a high degree of caution surrounding the global economy and commodity prices were generally weaker.

The Reserve Bank Minutes confirmed that there was less concern surrounding the inflation outlook and there was a suggestion that borrowing costs could be lowered if forthcoming inflation data is more favourable. The data influences were limited with a decline in business confidence already priced in.

Australian dollar volatility is likely to remain high and, despite buying support on dips, there will be a high risk of renewed losses over the next few weeks.

Canadian dollar:

The Canadian dollar pushed to highs near parity against the US currency during the week as risk appetite improved, but it was unable to sustain the gains and generally consolidated in a 1.01-1.02 range later in the week.

There was a weaker Bank of Canada business survey, although it was broadly in line with expectations. There were some hopes that the North American economy was stabilising which provided Canadian dollar support, although there were also doubts surrounding commodity prices as copper prices fell sharply.

The Canadian dollar will continue to be influenced strongly by trends in risk appetite and commodity prices. The net risks suggest that overall depreciation is likely.

Indian rupee:

The rupee was subjected to further volatility during the week and continued to flirt with important support levels near the 50 level against the US currency. There was speculation that the Reserve Bank would intervene which curbed speculative selling.

There were doubts surrounding the domestic and international economies. There were also fears that the central bank would have to increase interest rates further to curb inflation even though the economy appears to be weakening. Equity markets also remained extremely fragile which curbed underlying rupee support.

There will be persistent doubts surrounding the global and domestic economy which will maintain the potential for Reserve Bank action to stem losses.

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The Hong Kong dollar hit resistance in the 7.7750 area against the US currency during the week and dipped back to the 7.78 region although selling was contained.

There were continuing fears surrounding the global economy which limited demand for the Hong Kong dollar, especially as there were also continuing doubts surrounding the mainland Chinese economy. Regional equity markets were also generally fragile.

The Hong Kong dollar should remain resilient with speculation over a medium-term revaluation offering protection from fears surrounding the Chinese outlook.

Chinese yuan:

The Chinese yuan recovered from initial weakness and strengthened towards the 6.37 area against the dollar. The central bank appeared to deliberately weaken the currency at the end of last week in protest at the US Senate currency bill, but it tolerated a firmer tone during the current week.

There were further doubts surrounding the Chinese economy which dampened yuan demand as there were persistent fears over a hard landing for the economy. The Shanghai stock-market also weakened to 2011 lows. There was, however, also a trend towards divergence in analyst opinions on the economy.