Weekly Forex Currency Review 22-02-2008

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Overall strategy: The latest data releases will increase US recession fears and the dollar will be vulnerable on growth and yield grounds. Selling pressure should still be tempered by increased fears over the global economy, although the overall US currency risk profile has increased.  Uncertainty over the impact of the US downturn will maintain the risk of volatile trading conditions.                    

Key events for the forthcoming week

Dollar:

Confidence in the US economy will remain very fragile in the short-term with continuing recession fears after the recent data releases. There will also be pressure for further Federal Reserve interest rate cuts, although the central bank will face an increasingly complex set of policy issues given the increase in inflation. Fears over the global economy will continue to provide defensive support for the dollar, although the impact will be much more limited if the global economy appears able to de-couple from the US. Overall, the dollar should be able to avoid heavy losses from current levels.     
      
The dollar fluctuated in narrower ranges over the first half of the week and a rally on Monday when US markets was quickly reversed. The dollar was then subjected to further selling as recession fears increased with losses against all major currencies.

US housing starts were little changed at a depressed annual rate of 1.01mn for January while building permits edged lower. The NAHB housing index edged higher to 20 in January from 19. Jobless claims fell slightly to 348,000 in the latest week, but continuing claims continuing to edge higher which suggested that it was more difficult to get new jobs.

The Philadelphia Fed index weakened further to -24 in February from -20.9 previously. This reading was a 7-year low and put the index firmly in recession territory. Similarly, leading indicators also signalled recession conditions.

Minutes from the Fed's January meeting pointed to the downside economic risks and the growth forecasts were also lowered with the Fed stating that relatively low interest rates would be required for a time. Inflation estimates were also increased in the report while the Fed stated that cuts could need to be reversed rapidly once the economy stabilises. Markets continued to price in further interest rate cuts.

US consumer prices rose 0.4% in January as food and energy prices increased which pushed the annual increase to 4.3%. There was a core increase of 0.3% for the month with pushed the underlying rate to a 12-month high of 2.5%.

There were further rumours and ratings stresses surrounding the US bond insurers and this triggered important shifts in sentiment as equity markets also found it difficult to sustain trends.

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The Euro will look to gain support from expectations that the Euro-zone will out-perform the other major economies in the very short-term. The ECB will also look to resist pressures for a near-term cut in interest rates. The overall economic risks are still liable to increase and the Euro-zone economy is likely to prove brittle as there is still the strong probability of a sharp slowdown in growth. There will also be an increasing threat of internal divisions within the Euro-zone which will unsettle the currency.            

The Euro retained a generally firmer tone over the week with advances against most major currencies and a peak above 1.48 against the dollar. There was a partial reversal against the low-yield currencies on Thursday as US recession fears increased.

There were further downgrades of the Euro-zone 2008 GDP growth forecasts, although the market impact was limited. The preliminary PMI reports for the manufacturing and services sectors were both at 52.3 for February which provided some relief over near-term economic trends.

The inflation data remained firm with elevated reading for German producer prices and ECB officials continued to warn over inflation trends.

The Euro-zone current account moved into deficit for December with a shortfall of EUR10.3bn which raised some concerns over deteriorating competitiveness.

The Euro was unsettled to some extent by reports from the German Finance Ministry that the Landesbank system was in crisis.

Yen:  

Confidence in the domestic economy will remain generally weak in the short-term with the Bank of Japan not in a position to increase interest rates even with some inflation concerns. International trends will tend to remain the dominant factor in the short-term and the yen will be vulnerable if there is a sustained increase in risk tolerances. Capital repatriation is liable to increase over the next few weeks which should provide important yen protection and selling pressure on the currency should be contained by general risk aversion.       
                    
The yen has been generally weaker over the past 7 days, although the Japanese currency was confined to relatively narrow ranges against the dollar for much of the time. The yen strengthened back to test resistance around 107.15 on Thursday.

The Bank of Japan continued to voice concerns over the economic outlook in its latest assessment of the economy while the January minutes also pointed to downside risks.

The Japanese all-industries index dipped 0.2% in December with a 0.4% annual decline, maintaining the sequence of generally weak readings.

The headline trade account moved into deficit for January, although this is a normal feature for the month due to seasonal considerations.

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The most recent data will ease fears over a very sharp deterioration in the economy and the Bank of England will want to take a cautious stance on interest rates given the persistent inflation fears. The economy is still liable to weaken sharply and the bank may still be forced to relax policy more aggressively later in 2008. There will also be a continued lack of confidence in the fundamentals given the wide current account deficit. Sterling rallies are still likely to be limited in the short-term even though the risk of heavy selling has eased for now.       
 
Sterling weakened to lows below 1.94 against the dollar during the week, but recovered back to levels above 1.9650 as the dollar stumbled. Sterling found support around 0.7580 against the Euro, but with net losses for the week.

The Bank of England minutes from the February MPC meeting recorded an 8-1 vote for a cut in interest rates of 0.25%. Blanchflower dissented and called for a more aggressive 0.50% cut as a precaution against a severe slowdown.

Bank officials were also cautious over the economy's prospects, although growth fears were again balanced by unease over the inflation outlook.

The retail sales data was stronger than expected with a monthly increase of 0.8% which pushed the annual increase back above 5.0% given the weak release in January 2007. Prices were still lower over the year as discounting prevailed.

The CBI industrial orders survey edged higher to +3 in February from +2 the previous month. The latest budget data was also better than expected as tax revenue was strong and this combination eased immediate fears over a very sharp slowdown.
 
Swiss franc:

There are likely to be further doubts over the Swiss economy and there will be some speculation over a cut in interest rates later in 2008. The National Bank will be very reluctant to relax policy in the short-term, especially as inflation has moved higher. The franc moves will remain correlated closely with levels of risk aversion and an easing of tensions would tend to weaken immediate franc demand. The Swiss currency is unlikely to be subjected to strong selling pressure given the current risk profile.   
 
The Swiss currency weakened to lows beyond 1.10 against the dollar and 1.62 against the Euro as markets favoured higher-yield instruments. The franc recovered from lows after the depressed US Philadelphia Fed reading, especially against the dollar.

Swiss producer prices rose 0.5% in January with the annual increase at 3.7% which was the highest rate since 1990.

The National Bank maintained its GDP growth forecast of 2.0% for 2008, although markets were less confident over the outlook with some underlying speculation over an interest rate cut later this year.

The trade surplus increased to CHF1.22bn in January from CHF0.18bn the previous month as there were solid gains for exports.

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The Australian dollar retained a firm tone over the week and tested levels above the 0.92 level against the US dollar as US confidence weakened.

The Reserve Bank's minutes from February's meeting were generally hawkish with a suggestion that a 0.50% rate increase was considered at the meeting due to inflation concerns. Reserve Bank officials also took a generally tough stance on inflation and monetary policy during the week.

The Australian currency drew support from the strength of metals prices during the week, especially the gains in industrial metals prices.

The domestic releases were limited with annual wage growth of 4.2% for the fourth quarter which failed to have a significant impact.

The yield differential will remain compelling in the short-term, although there will still be strong barriers to gains given the global growth fears

Canadian dollar:

The Canadian dollar dipped to lows around 1.02 against the US dollar before securing some respite as the US currency was subjected to fresh selling pressure.

The wholesale sales data was significantly weaker than expected with a 2.9% annual decline for December.

The headline consumer inflation rate was 2.2% for January. Core prices rose 0.1% over the month with the annual rate declining to 1.4% which was the lowest rate for 30 months. The low rate maintained expectations of a further cut in interest rates.

The Canadian currency drew some support from high oil and commodity prices, although the economic uncertainties tended to dominate.

The net risks still point a weaker Canadian dollar as domestic economic fears increase, although heavy losses should be resisted in the current environment.

Indian rupee:

The rupee continued to weaken over the first half of the week and dipped to a five-month low of  40.25 against the US currency. The rupee reclaimed the 40.0 level later in the week, but still had a generally weaker trend.

A significant dollar shortage developed in the market which boosted the US currency, although stresses eased over the second half of the week  The rupee was undermined by doubts over capital account trends, although the overall evidence did not suggest that there had been sizeable outflows..

The rupee was undermined by the high level of oil prices in the market with crude prices again challenging the US$100 per barrel level.

Fears over the global economy and a more cautious investment stance will maintain rupee vulnerability. Heavy losses should be avoided given improved yield spreads.

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The Hong Kong currency has continued to fluctuate around the 7.80 central peg against the US dollar with highs around 7.7950 as the US currency stumbled.

Arbitrage activity remained an important influence with Hong Kong dollar selling easing sharply on any moves towards the 7.8050 level. The local currency also gained some support from increased demand ahead of forthcoming IPO offerings

The strength of Asian currencies including further gains for the yuan provided some support to the Hong Kong dollar.

The Hong Kong currency should secure further support towards 7.8050 against the US dollar with a reluctance to sell the local unit beyond this level.

Chinese yuan:

The yuan strengthened to highs to near 7.14 against the US dollar, a fresh post-float high for the Chinese currency and the yuan was holding firm on Friday.

Volatility was potentially increased by reduced activity in the onshore forwards market as the regulators tightened control and market makers stopped quoting prices.

Inflation issues were a dominant influence with the consumer inflation rate rising to an 11-year high of 7.1% for January. The central bank promised new policies to combat inflation and also promised greater currency flexibility. This fuelled additional market speculation that there would be a faster rate of yuan appreciation over the next few months

The yuan is likely to strengthen further in the short-term, especially with the central bank  steering the currency stronger to help combat inflation. Fears over a sharp slowdown in the economy could reverse yuan gains later in 2008.

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