Weekly Forex Currency Review 23-11-2007

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Overall strategy: The developments in global risk conditions will remain very important in the short-term and liquidity constraints will increase the threat of a further unwinding of carry trades which would strengthen the yen and Swiss franc. The dollar is likely to remain vulnerable in the short-term, but with an increasing threat of central bank action to support the currency.                  

Key events for the forthcoming week

Market analysis

Dollar:

There will be increased fears that weakness in the housing and financial sectors will damage the wider economy and push the economy into recession. There will also be market expectations that the Federal Reserve will cut interest rates again to support the economy. The US currency will gain some relative support from increasing evidence of difficulties elsewhere, especially as the US trade account is continuing to improve. There is also the potential for central bank action to help stabilise the US currency. Sentiment will remain negative in the short-term and fears over reserve diversification will continue to limit recovery attempts.    
      
The dollar remained under pressure over the week with renewed post-1945 lows on a trade-weighted index while there were fresh record lows beyond 1.4950 against the Euro before a recovery as US currency sentiment remained depressed.

There was a small increase in US housing starts for October, but permits remained weak while single-family house starts continued to fall. The NAHB housing index stabilised at 19 in the latest month. Other data releases were limited with a small drop in jobless claims while consumer confidence was little changed at near two-year lows.

The Federal Reserve minutes from October's meeting stated that the decision to lower rates was a close call while rate cuts could be reversed readily.

The Fed, however, also downgraded its GDP growth forecasts for 2008 with a new 1.8 - 2.5% forecast range which reinforced market concerns over the economy.

Confidence in the economy remained weak following a profits and lending warning from mortgage lender Freddie Mac with increased fear over the implications of financial-sector weakness. Despite the Fed comments, markets continued to price in fully a further interest rate cut for December.

US Treasury Secretary Paulson stated that the dollar would rebound and reiterated the strong dollar policy, but there was no evidence of actual intervention.

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There will be further concerns over the Euro-zone growth outlook in the short-term, especially if banking-sector fears intensify. The ECB will remain concerned over inflation and will still retain a tough policy, at least in public, as containing inflation expectations will be a key policy objective. There is, however, still no real scope for interest rates to be increased. There is likely to be increased political and industrial pressure for Euro gains to be capped while calls for rate cuts will also increase if growth fears intensify.   

The Euro has retained a firm tone against high-yield currencies over the past seven days. The currency lost some ground against the Japanese yen and Swiss franc as global stock markets came under pressure.

Euro-zone industrial orders fell 1.6% in September which cut the annual growth rate to a nine-month low of 2.0% while French spending growth also weakened sharply. The Euro-zone November PMI index for manufacturing rose to 52.6 from 51.5 previously, but the services index fell significantly to 53.7 from 55.8 and overall concerns over growth trends increased.

There were expressions of concern over the Euro's level with Euro-Group head Juncker stating that it was no longer possible to take a benign approach to the Euro gains while German Chancellor Merkel also expressed concern over the Euro.

ECB President Trichet also stated that he was against rapid and brutal currency moves. These comments indicate that concern over the Euro's strength is increasing, although Trichet held back from actually describing the recent currency moves as brutal. This is an important distinction and still signals reservations over intervening.

The September Euro-zone current account surplus fell to EUR0.6bn from a revised EUR4.5bn previously, although trade is still not a major issue at this stage. There was also no evidence of major capital outflows which will offer Euro reassurance.

Denmark announced that it would hold another referendum on whether to introduce the Euro, but this did not have a significant impact.

Yen:  

The short-term yen moves will continue to be dominated by levels of global risk aversion and the outlook for carry trades. The yen will be sold at times on yield grounds, although the most likely outcome is that there will be a further net reduction in carry trades as risk aversion remains high. There will also be some risk of carry-trade capitulation which would trigger sharp gains. There is evidence of increased official tolerance for yen gains, but there will still be opposition to disorderly markets which will slow yen gains.                    
                    
The Japanese currency strengthened against all major currencies over the week. Against the dollar, the yen broke through the August 2007 highs and pushed to 24-month highs near 107.50 before a retreat to 108.0.

The yen gained important strength from an unwinding of carry trades as risk aversion remained high due to persistent credit-related fears. The Japanese capital account data was strong in the latest week with increasing evidence of capital repatriation.

Comments from Finance officials over the yen gains were generally limited with no strong warnings against the moves which suggests some tolerance of a stronger yen.

The government did, however, express concern over the domestic growth trends with concerns over the implications of weaker US growth.

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There will be further concerns over the UK economy in the short-term with a particular focus on the housing sector as tighter lending standards and a credit contraction will damage activity. There is an increasing probability of a December Bank of England interest rate cut, especially in view of the upward pressure on market rates seen over the past two weeks. The UK currency will also tend to weaken if there is a sustained unwinding of carry trades. The net risks still point to Sterling depreciation despite intermittent rallies.                    
 
Sterling remained under pressure against the Euro and tested support levels beyond 0.72 against the Euro, the weakest level for over four years. The UK currency was able to advance against the dollar as the US currency remained under sustained selling pressure with temporary gains to above 2.07 on Friday.

Minutes from November's MPC meeting recorded a 7-2 vote for unchanged interest rates with Blanchflower and Gieve voting for an immediate cut in rates.

UK Libor rates continued to increase with rates pushing above the 6.50% level which was a two-month high and 0.25% above the level at the time of November's MPC rate decision to hold rates unchanged.

The economic data generally suggested a slowdown in growth as money supply growth slowed, although the CBI industrial survey was resilient. Third-quarter GDP growth was revised down to 0.7% from 0.8% originally.

The Rightmove house price index fell 0.7% for November which cut the annual increase to below 8.0% while lending criteria continued to tighten.

Swiss franc:

The Swiss franc moves will tend to be dominated by levels of risk aversion and carry trades in the short-term. The underlying risk profile is likely to remain at elevated levels which will continue to provide important underlying franc support. The domestic economic fundamentals should also remain robust in the short-term. The franc should be able to retain a firm tone, although there should be only limited scope for further advances against the dollar after strong gains.        
 
The franc strengthened to 1.6330 against the Euro with a test of the Euro's long-term up-trend line against the Swiss currency. The franc also strengthened to record highs near 1.09 against the dollar as the US currency remained under heavy selling pressure.

The Swiss currency gained consistent support from an increase in risk aversion and a reduction in carry trades as global stock markets were subjected to further downward pressure while credit fears also increased.

The trade data remained solid with a CHF1.56bn surplus for October as export growth remained robust while the latest employment data was also firm.

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The Australian dollar was unable to reclaim the 0.90 level against the US dollar and weakened to lows near 0.8650 even though the US currency was generally depressed.

The local currency was unsettled by a sustained increase in risk aversion over the week as carry trades were cut back with some repatriation of flows back to Japan.

The Australian dollar was also undermined by a sharp drop in industrial commodity prices, although gold prices held generally firm.

There were no significant domestic economic developments during the week to influence markets. The currency was unsettled slightly by uncertainty ahead of the general election on November 24th with some fears over an indecisive result.

The key short-term feature is still likely to be a sustained increase in volatility with the currency vulnerable to further selling pressure if risk aversion remains high.

Canadian dollar:

The Canadian dollar had a generally softer tone and weakened to lows just beyond 0.99 against the US dollar. The currency secured some protection from the persistent strength in oil prices, but metals prices fell sharply which was a damaging factor.

The inflation data was significantly weaker than expected with a 0.3% decline in consumer prices for October while a 0.2% decline in core prices cut the core annual growth rate to below 2.0%. The Canadian retail sales data was also weaker than expected with a 0.2% decline for September.

The weak data reinforced speculation that the Bank of Canada would consider an interest rate cut at the December interest rate meeting.

Government officials were still uneasy over Canadian dollar strength, but the rhetoric was calmer following the partial Canadian currency retreat from recent highs.

There is the potential for the Canadian currency to fluctuate around parity in the short-term with speculation over lower interest rates curbing any renewed rally attempts.

Indian rupee:

Rupee volatility was relatively contained over the week with the currency able to withstand an increase in global uncertainty and risk aversion. The rupee weakened slightly to around 39.55 against the US currency on Friday.

There was some evidence of weaker capital account trends and the local stock market weakened consistently, but underlying confidence remained firm which limited the negative rupee impact.

The central bank continued to intervene to restrain the rupee, especially during the first half of the week The trade minister warned that rupee strength was a problem.

Overall rupee confidence should remain firm for now, although there will be the persistent risk of higher volatility and losses if global risk aversion intensifies.    

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The Hong Kong dollar was contained in a 7.77 - 7.78 range for the week, generally moving in line with trends in local money markets.

There were still erratic trends in local inter-bank markets which also triggered fluctuations in the local currency.

The HKMA stated that it would look to improve the currency peg operations, but again rejected any move away from the existing currency peg.

Despite further fluctuations, the Hong Kong dollar should be able to find near-term support stronger than the 7.80 central peg, especially with weak US sentiment.

Chinese yuan:

The yuan has had a firmer tone over the week with fresh record highs beyond the 7.40 level against the US dollar on Friday, although the central bank continued to resist strong appreciation.

There was a temporary dollar shortage as the bank implemented higher reserve requirements and this provided some initial support to the US currency, but this impact faded towards the end of the week.

There was persistent pressure on China from European officials to let the yuan strengthen at a faster pace with a focus on the Sino-European summit due next week.

The underlying trend is likely to be for further yuan appreciation with the central bank continuing to smooth volatility. There remains a small chance of a significant one-off revaluation.