Weekly Forex Currency Review 23-02-2007

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Overall strategy

Carry trades and the flow of funds into high-yield currencies will remain extremely important, especially with the Euro/dollar rate struggling to break out of relatively narrow ranges. Market interest in selling low-yield currencies will persist, but is looking increasingly dangerous.     

Key events for the forthcoming week

Dollar

The higher than expected US inflation rate will dampen expectations of lower interest rates within the next few months and this will provide some dollar protection. There will still be uncertainties over economic growth trends while structural uncertainties will be a negative background factor. The US currency should be able to avoid heavy losses given the yield structure, but will find it difficult to regain momentum unless defensive demand for Treasuries increases. The dollar will need to push through 1.3060 against the Euro to boost sentiment.

After weakening to lows near 1.3190 against the Euro, the dollar secured some respite, but was unable to strengthen back through the 1.3060 level.

Headline US consumer inflation matched market expectations with a 0.2% increase for January, but the core rate was 0.3% with the annual rate rising to 2.7% from 2.6%, still significantly above the Federal Reserve’s unofficial 2.0% ceiling. Elsewhere, jobless claims retreated to 332,000 in the latest week from 360,000 previously.

The FOMC minutes from January’s meeting reiterated that members were more confident that the economy could achieve moderate growth with a gradual easing of inflationary pressure. The Federal Reserve maintained a tightening bias for interest rates despite discussion of a switch to a neutral stance.

The higher than expected inflation rate caused some adjustment of interest rate expectations with markets less confident that the Fed would be in a position to cut interest rates later this year.

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Markets will remain very confident over a March ECB interest rate increase and the Euro-zone economic data has remained generally encouraging which will sustain Euro confidence. There is still the potential for some fluctuations in longer-term interest rate expectations and the Euro will find it difficult to secure further gains given the amount of tightening already priced in.

The Euro rose to a record high against the yen, but was subjected to profit taking against the dollar and Sterling after pushing to six-week highs earlier in the week.

German GDP growth was confirmed at 0.9% for the fourth quarter, but the breakdown was less favourable with weak domestic demand. The French GDP figure was revised to 0.6% compared with a 0.6-0.7% estimate previously. The German IFO index weakened slightly to 107.0 in February from 107.9 in January.

ECB members continued to take a tough stance on monetary policy with a flurry of tough comments from officials. Market forecasts of ECB interest rates edged higher over the week with some banks calling for an increase in rates to 4.5% later this year.

Yen  

The yen has failed to benefit from the Bank of Japan interest rate increase and the Japanese currency will remain vulnerable on yield grounds with nominal rates at 0.5%. The longer-term capital flows have been more positive for the currency and seasonal trends will be a significant influence over the next few weeks with the potential for capital repatriation. There will still be the risk of a sharp yen correction stronger, especially if the dollar fails to push above 122.0.
                    
The yen was unable to strengthen through the 119.0 level against the dollar and weakened consistently over the week with lows beyond 121.5 against the US dollar.

Ahead of the decision, markets were evenly divided on the Bank of Japan interest rate decision. In the event, the bank decided on an increase to 0.50% by an 8-1 vote which pushed nominal rates to the highest level for 10 years.

Bank Governor Fukui stated that the bank would maintain an accommodative policy and continue to adjust interest rates gradually over the next few months with markets confident that rates would be left on hold for the next few months.

There was still strong market interest in carry trades with the yen weakening to a fresh record low against the Euro after the interest rate decision.

The trade account recorded a rare January surplus and the latest capital account data recorded further strong inflows over the week.

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Sterling remains vulnerable to some downgrading of interest rate expectations, especially after the Bank of England minutes, but markets will still be expecting an increase in rates over the next 2-3 months which will provide important protection. Domestic housing trends will be important while volatility will be an important risk, especially with Sterling gaining support from carry trades. Sterling should find further near-term support close to 1.94 against the dollar.

Sterling weakened to a six-week low against the Euro at 0.6755 before correcting stronger to 0.6700 over the second half of the week. The UK currency found further support below 1.95 against the US dollar.

The Bank of England minutes recorded a 7-2 vote for unchanged interest rates in February with the two dissenters voting for a rate increase to 5.50% to contain inflation. The bank retained a tightening bias, but the majority of members wanted to wait for further evidence, especially as wage costs appeared under reasonable control.

The CBI industrial trends survey was stronger than expected with the headline output index at the highest level since 1995. Money supply and mortgage lending data was firm while credit card borrowing remained weak according to the latest data.

Sterling was undermined temporarily by Bank of England comments that depreciation of the exchange rate will probably be needed to correct the current account deficit.

Swiss franc

The National Bank will be reluctant to accelerate interest rate increases and will also be strongly opposed to currency intervention. The franc will, therefore, remain vulnerable to selling pressure on yield grounds, especially while there is strong global  interest in carry trades. Nevertheless, the defensive qualities are still likely to be seen as more important over the next few weeks as a whole with the franc finding support near 1.63 against the Euro. 
 
The franc was unable to secure a recovery against the Euro during the week, weakening back to 7-year lows. The Swiss currency was also blocked close to 1.23 against the dollar even though the franc had a generally firm trend.

The Swiss currency was undermined by interest in selling low-yield currencies with weakness seen in tandem with renewed Japanese yen depreciation. The trade account remained robust with a CHF1.27bn January surplus as exports grew strongly.

Inflation indicators remained benign and there were no expectations for a faster pace of National Bank tightening. Bank Chairman Roth did warn over franc weakness, but effectively dismissed the potential for intervention to strengthen the franc.

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The Australian dollar found support close to 0.78 over the week and strengthened to highs around 0.7915 before drifting weaker as momentum faded.

Reserve Bank Governor Stevens stated that a further increase in interest rates was still more likely than a cut, although the governor was more confident over the inflation outlook than six months ago. Overall yield spreads moved in the Australian dollar’s favour and the currency was supported by higher gold prices.

There was some caution over carry trades ahead of the Bank of Japan interest rate decision, but there was renewed interest in high-yield currencies following the central bank rate increase as carry trades returned to dominance.  

The Australian dollar will gain support on yield grounds, but will struggle to extend gains, especially given potential volatility in capital flows.
 
Canadian dollar

The Canadian dollar secured further significant gains over the week with highs just  beyond 1.16 against the US currency before stabilisation around 1.1620.

The domestic economic data was stronger than expected with retail sales rising by a robust 2.3% for December. The Canadian dollar also secured support from an increase in oil prices to near US$61 p/b during the week.

The January consumer inflation data failed to have a significant impact on interest rate expectations or the local currency with the core annual rate of 2.1% close to the middle of the bank’s 1-3% target range.

Overall, the currency should be able to resist renewed heavy losses, but will struggle to extend short-term gains.

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The rupee continued to hit tough resistance near the 44.05 level against the dollar and retreated significantly to 44.25 later in the week. The central bank appears to have intervened fairly aggressively to prevent the rupee breaking through the 44.0 level and the intervention encouraged a covering of short dollar positions.

The rupee was also undermined by an increase in oil prices as importers stepped up dollar buying plans due to speculation that the rupee had reached a near-term peak.

Regional currency trends remained important and the weaker yen trend following the Bank of Japan interest rate decision also undermined the rupee.

The rupee is liable to remain blocked close to the 44.05 level , although losses from current levels should be limited unless there is a sharp drop in the local stock market.

Hong Kong dollar

Hong Kong markets were shut early in the week for New Year holidays and overall trading activity was subdued with a HKD7.8100 – 7.8130 range against the US dollar.

The Hang Seng index remained strong over the week and the capital inflows into the market supported the local currency.

There was, however, a rise in US yields after the US inflation data and this was a negative factor for the Hong Kong dollar as it encouraged renewed arbitrage activity.

A narrow 7.8100-7.8150 range against the dollar is liable to persist in the short-term with yield trends preventing Hong Kong dollar gains.