Weekly Forex Currency Review 22-06-2007

Overall strategy

Carry trades will continue to have a very important impact on markets with most currency pairs being influenced by the shift of funds into high-yield currencies. Volatility levels are liable to rise as capital flows will be vulnerable to a sharp reversal, especially if credit conditions deteriorate. Yield factors and optimism over US growth should provide some further support to the US currency, but firm gains are unlikely. 

Dollar

Underlying confidence in the US economy should refmain firm in the short-term with the manufacturing sector likely to sustain a recovery. The housing sector will remain a drag on the economy and rapid growth is unlikely. The US currency will need a clear threat of renewed tightening by the Federal Reserve to secure firm buying support. There is also likely to be dollar selling on significant rallies as central banks diversify reserves, but a general increase in risk aversion would underpin the currency on a flow of funds into Treasuries.      

The dollar has been confined to narrow ranges over the past week with markets looking for fresh direction. The US currency generally traded within a 1.3360 - 1.3440 range against the Euro and was mixed against the other major currencies.

US housing starts fell 2.1% in May to an annual rate of 1.47mn while permits increased to 1.50mn which suggests some stabilisation in the construction sector.

The Philadelphia Fed survey rose strongly to a reading of 18.0 in June from 4.0, the strongest figure for over two years, with a robust reading for orders.

US Treasury bond yields fell over the first part of the week, but there was a renewed increase in yields over the second half of the week with some rumours of hedge-fund selling pushing yields higher.

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The ECB remains on track to sanction a further interest rate increase during the third quarter which will underpin the Euro in the short-term, especially with capital flows from Japan. The Euro-zone data has still been firm, but the latest evidence has been more mixed and there is the threat of a slowdown which would dampen expectations of a further aggressive ECB tightening. There will also be the risk of property-related stresses in the market which will lessen the potential for Euro gains.      

The Euro had a mixed week with a net advance against low-yield currencies and a record high against the yen while there has been a retreat against higher-yielding currencies.

The German ZEW index fell to 20.3 in June from 24.0, the first decline for 2007 while the IFO index also weakened to 107.0 in June from 108.6 the previous month.

The preliminary manufacturing PMI index for June rose to 55.4 from 54.9 the previous month with the composite index also rising.

There were weak readings for French consumer spending and Italian consumer confidence which resulted in some unease over the outlook for consumer spending in these countries.

ECB officials continued to take a firm stance in remarks during the week with markets still expecting further increases in interest rates.

Yen 

Reduced expectations of a near-term Bank of Japan interest rate increase will continue to undermine the yen in the short-term with a further shift of funds into high-yield currencies. The volume of yen selling could intensify if risk tolerances stay high. An increase in risk aversion and tightening global liquidity will slow credit growth and this will eventually lessen the potential for aggressive yen selling. There is still the potential for a rapid correction stronger as liquidity contracts.        
                    
The Japanese currency remained on the defensive during the week and tested four-year highs against the dollar close to 124.0 with the yen also falling to record lows against the Euro.

The second-quarter business confidence index weakened significantly to -0.9 from 6.5 which raise some concerns over the Tankan report next week. The trade account remained strong for May as exports rose 15.1% over the year.

There were no significant protests against yen weakness from senior Japanese administration officials during the week

Former top financial official Sakakibara called for interest rates to be increased to over 1.0% to prevent further distortions and a speculative bubble involving carry trades.

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Increased expectations of a July interest rate increase will underpin Sterling in the short-term, especially with markets also pricing in a rise in rates to at least 6.0% later in 2007. Sterling will also tend to gain support if the global flows into high-yield currencies persist, but these flows will be unstable. The consumer and property sectors are liable to slow which will tend to curb strong Sterling buying with the thfreat of sharp medium-term depreciation.      
 
Sterling strengthened over the week as markets priced in further Bank of England tightening. The UK currency rose to highs above 1.9950 against the dollar and a four-month high of 0.6710 against the Euro.

The Bank of England minutes recorded a 5-4 vote for unchanged interest rates in June with Bank Governor King among the minority who pushed for a further immediate increase in rates.

The minutes increased speculation over a further rate increase at the July MPC meeting while futures markets were pricing in interest rates above 6.0% by the end of 2007.

The CBI survey was firm for June with the orders component rising to +8 from +5 previously while pricing pressures eased slightly.

Money supply and bank lending data was also strong according to the latest monthly figures.

Swiss franc

The domestic fundamentals will remain strong in the short-term which will provide background franc support. The Swiss currency will remain vulnerable to capital outflows if there is sustained interest in carry trades. The National Bank will be more concerned over the inflation implications of a weak currency and there is likely to be further verbal intervention to discourage aggressive selling. Volatility levels are liable to increase, but overall franc gains are realistic as credit conditions tighten.
 
The Swiss currency found support weaker than 1.6650 against the Euro, but was unable to make strong headway as rallies quickly met selling pressure. The franc fluctuated around 1.24 against the dollar.

Producer prices rose 0.9% in May with the annual inflation rate rising to 2.8% from 2.5% the previous month. There were further warnings over franc weakness from National Bank officials, especially in view of the inflation data.

The trade surplus increased to CHF1.26bn in May as real exports rose 14% over the year. Industrial production fell for the first quarter, but there was a solid annual increase.

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Over the week, the Australian dollar pushed to 18-year highs against the US dollar with levels above the 0.8475 level as confidence remained strong.

There was little in the way of domestic economic data to give market direction during the week, but survey evidence remained generally firm.

There were further yield-related capital flows into the Australian dollar which underpinned the currency and sentiment towards the currency remained robust.

Australian dollar confidence will remain strong in the short-term, but it remains vulnerable to a sharp correction on global market stresses with volatility liable to increase.

Canadian dollar

The Canadian dollar hit resistance close to 1.06 against the US dollar before weakening back to lows around 1.0750 on weaker economic data.

Headline consumer prices rose 0.4% in May while there was a 0.3% core increase. This cut the annual core increase to 2.5% from 2.5% reflecting the strong price increases last year.

The wholesale sales data was weaker than expected with a 3.1% decline for May while the increase in retail sales was held to 0.4% with underlying sales unchanged over the month.

The Canadian currency was supported by a rise in oil prices during the week and markets were still looking for a July Bank of Canada interest rate increase.

Overall, the Canadian dollar should retain a firm short-term tone on expectations of higher interest rates, although consolidation is still likely to dominate.

Indian rupee

The rupee has secured a firm tone over the past week, but trading ranges have been generally narrow with the rupee settling close to 40.75 against the dollar on Friday.

There have been further capital inflows into Indian markets and there has also been a demand for funds ahead of the ICICI Bank IPO offering.

The rupee has been constrained by persistent central bank intervention to curb currency appreciation with the bank opposing gains through the 40.50 level.

High oil prices have also undermined the rupee while there has been speculation over additional credit controls to curb speculative capital inflows.

The rupee should remain firm in the short-term, but capital inflows are liable to be more cautions with the potential for at least a small correction weaker and the possibility of a larger correction.

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The Hong Kong dollar has again been trapped in relatively narrow ranges over the past week and was holding around 7.8130 on Friday.

There have been expectations of  fund inflows following the expansion of China's overseas investment QDII scheme which has supported the Hong Kong dollar.

Forthcoming IPO offerings also triggered demand for the Hong Kong currency.

The local currency was still undermined by arbitrage activity as US yields retained a firm tone which widened yield spreads over the Hong Kong dollar slightly. 

The currency will remain vulnerable to arbitrage selling and any sharp drop in the local stock market would risk a Hong Kong dollar move to 7.82 against the US dollar. 

Chinese yuan

The Chinese yuan has continued the process of gradually strengthening over the past week. The currency strengthened for six consecutive sessions before edging lower to 7.622 against the dollar on Friday.

The central bank has maintained tight control of the exchange rate by providing strong guidance to market rates.

US officials have continued to push for a faster rate of yuan appreciation and a former central bank official also stated that the currency should be allowed to appreciate faster to avoid domestic overheating.

The central bank has continued to reject international calls for a faster yuan appreciation.

Officials will retain tight control of the exchange rate, but the yuan should gain steadily over the next few weeks with the authorities continuing to promote gradual appreciation.