Weekly Forex Currency Review 24-08-2007

Overall strategy

The degree of credit-related fears will continue to be a very important market factor over the next few weeks. It will be difficult for high-yield currencies to extend recoveries as there will continue to be greater caution over carry trades, especially with tighter lending practices. Unease over the US economy will continue to limit the scope for dollar gains and a key feature is liable to be a sustained increase in volatility.   

Key events for the forthcoming week

Dollar

There will be further unease over the US economy, especially with the threat of further job cuts in the mortgage sector and speculation over a slide into recession. The immediate credit conditions have eased marginally, but there will still be pressure on the Federal Reserve to cut interest rates. This pressure will intensify if there is evidence of deterioration in consumer spending. Defensive demand for the dollar will remain an important factor at times and volatility levels will remain high as underlying credit stresses will tend to persist. The dollar overall is unlikely to make strong gains given the economic fears.   
      
The dollar peaked against the European currencies at the end of last week as risk aversion peaked. The US currency gradually weakened against European currencies this week with a low around 1.3585 against the Euro, but with gains against the yen.

Following the discount rate cut last Friday, the Fed continued to inject funds into US money markets, but did not make any further adjustments to interest rates.

US money market rates dipped sharply in mid week as there was a sharp increase in safe-haven demand for US Treasuries. Tensions eased slightly later in the week as Wall Street rallied, but market rates remained below the Fed funds rate as pressure for a rate cut continued.

Following a meeting with Senate banking committee chairman Dodd, the Fed stated that it would use all tools that were available, but attempted to calm markets by stating that it was not alarmed over the current situation.

There was little in the way of US economic data with jobless claims little changed at 322,000 in the latest week which did not indicate an immediate labour-market shift.

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The ECB will look to resist pressure for interest rates to be held steady at the September meeting and a firm bank stance would underpin the Euro. There will still be unease over the financial sector, especially if further banking-sector bailouts are required. The economic data has remained firm, but confidence indicators have faltered and there will be the threat of increased political pressure on the ECB to resist higher interest rates if growth indicators deteriorate. The Euro will also be influenced strongly by cross rate trends and, overall, there are unlikely to be heavy Euro losses.            

The Euro remained under pressure against the dollar and yen at the end of last week, but the currency regained ground this week as risk aversion eased with a move back above 155.0 against the Japanese currency.

The ECB continued to add liquidity to stabilise money market conditions during the week while another German bank required emergency funding. The central bank maintained a firm stance on inflation and policy by stating that inflation was still the pre-dominant economic risk.

The German ZEW index weakened to -6.9 in August from +10.4 the previous month as confidence deteriorated.

The Euro-zone industrial orders rose by a strong 4.4% in June to record an annual increase of over 13%. The PMI index for August weakened to 54.2 from 54.9 in July which maintained expectations of a gradual slowdown in growth.

The Euro-zone trade and current accounts returned to surplus for June which eased any immediate fears over the competitive position.

Yen

Carry trades will remain the dominant short-term influence and any sustained improvement in risk aversion would tend to weaken the yen on a renewed flow of funds into high-yield currencies. Low Japanese interest rates will also maintain the temptation to sell the Japanese currency. There will, however, be greater caution over investing funds overseas which will continue to offer important currency protection. Volatility is liable to remain high with the Finance Ministry looking to stabilise the yen if the dollar moves below the 110.0 level.              
                    
The yen briefly strengthened through the 112.0 level against the dollar before weakening back to lows around 117.0 in choppy trading. The Japanese currency also corrected sharply from highs beyond 150.0 against the Euro.

Currency moves were influenced strongly by carry trade developments with an underlying improvement in credit conditions and firmer stock markets weakening the yen over the week as a whole.

The Bank of Japan left interest rates unchanged at 0.50% following the latest monetary meeting with a split 8-1 vote as Mizuno voted for an immediate increase.

Bank Governor Fukui warned over the risk of holding interest rates too low for too long, but did not give any clear insight as to when rates would be increased.

The latest capital account data recorded strong net inflows into Japan as risk aversion increased sharply with capital repatriation back to Japan.

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The stabilisation in stock market conditions will help underpin Sterling in the near term with a tentative revival in carry trades. The Bank of England is likely to hold policy steady in the short-term with the UK currency still gaining support on yield grounds as interest rates may not have peaked. Nevertheless, the UK fundamentals are liable to deteriorate with the debt position precarious and the threat of a significant housing downturn. The UK currency is liable to weaken over the next few weeks as a whole despite continuing volatility.             
 
Sterling found support below the 1.97 level against the dollar and managed to strengthen back above the 2.00 level late in the week as the US currency came under selling pressure. The UK currency advanced slightly to 0.6780 against the Euro.

Global risk aversion and carry trades had an important impact on Sterling over the week, especially with only limited data releases, and a tentative recovery in risk appetite supported the UK currency.

The latest CBI survey reported a recovery in the orders component to +9 from -6 the previous month which was a 15-year high.

There was evidence of an underlying slowdown in mortgage lending with re-mortgaging activity remaining strong. The latest evidence recorded a further increase in debt levels with household debt at over 160% of income.

Swiss franc

The Swiss economy is liable to slow slightly in the short-term, although the underlying fundamentals will remain sound. The National Bank will still consider a September interest rate increase if financial markets stabilise. The Swiss currency will tend to weaken if there is renewed interest in carry trades, but the net evidence suggests that markets will be much more cautious over the selling of low-yield currencies. The Swiss franc should remain generally firm despite intermittent selling pressure when carry trade interest revives.  
 
The Swiss franc strengthened against the Euro as risk aversion peaked with high close to 1.62 before a retreat to 1.64 as global stock markets recovered. The franc was confined in narrow ranges around 1.2050 against the dollar as cross-trade movements dampened movement against the US currency.

The KOF economic institute remained confident over the outlook and did not call for a cut in interest rates while the latest industrial ZEW survey showed some slowdown.

National Bank member Hildebrand stated that the financial market turbulence would have an impact on the Swiss economy and that the bank was ready to act if necessary, but the bank overall was still optimistic over trends.

Producer prices rose 2.8% in the year to July which will not have a significant impact on interest rate expectations. The trade account remained in strong surplus for July at CHF1.57bn with robust growth in exports.

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The Australian dollar found solid buying support below the 0.78 level against the US dollar during the week and strengthened to highs back above 0.82 late in the week as volatility remained high.

Australian dollar moves were dominated by global risk aversion levels and carry trades. The currency was able to strengthen during the week as global stock markets recovered and defensive US dollar demand declined.

There were no significant domestic economic developments during the week with market attention fixed firmly on the international trends.

Given an underlying tightening of credit, the Australian dollar is likely to face difficulties in extending the recovery against the US currency, although choppy trading conditions will continue.

Canadian dollar

The Canadian dollar had a generally stronger tone during the week with highs just beyond the 1.05 level against the US dollar from a low beyond the 1.08 level.

Domestically, retail sales fell 0.9% in June after a very strong 2.6% increase the previous month. Consumer prices rose 0.1% in July while core prices also increased by 0.1% over the month and the core annual inflation rate edged lower to 2.3% from 2.5%. Markets expected the Bank of Canada to hold interest rates steady.

A recovery in risk appetite helped support the Canadian currency during the week although volatility levels remained high.

Overall, the US dollar is likely to find support below the 1.05 level against the Canadian currency, but with only limited gains as volatility remains high.

Indian rupee

Indian rupee volatility has continued to be an important feature, although international conditions generally calmed as the week progressed.

The rupee strengthened back beyond the 41.00 level from lows beyond 41.50 the previous week before stalling and weakening to 41.10 on Friday.

The evidence suggested that the capital account was more stable this week, although there were still reservations over aggressive investment given tighter global credit. Speculation over a cut in US interest rates helped support the Indian currency.

The rupee was undermined by fears that the government's communist allies would withdraw support for a nuclear deal with the US.

Volatility levels are likely to remain higher in the short-term with a slightly weaker rupee trend realistic, although heavy losses should be resisted.

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The Hong Kong dollar was unable to hold near the 7.80 level against the US dollar and weakened back to 7.81 before holding close to 7.8090 on Friday.

There was strong second-quarter GDP growth of 2.0% while the inflation rate was held at 1.5% for July, but the domestic fundamentals did not have a major impact.

The HKMA did not cut the discount rate following the US move last Friday and also expressed strong confidence in the domestic monetary system.

A recovery in risk appetite encouraged some renewed interest in carry trades which weakened the Hong Kong dollar slightly. Caution continued to dominate with risk appetite still at reduced levels.

The Hong Kong dollar is likely to face further resistance close to the 7.80 level against the US currency even if volatility levels remain higher.

Chinese yuan

The Chinese yuan resisted further depreciation this week after a softer tone during August. Following a period of uncertainty, the yuan strengthened sharply on Friday with gains to 7.566, one of the largest 24-hour gains since the 2005 float.

Over the first half of the week, there was further uncertainty over China central bank's intentions towards the yuan, especially with volatile global capital flows.

The weaker US currency and a recovery in risk appetite helped underpin the Chinese currency during the week with the authorities more comfortable in letting the currency strengthen.

The Chinese central bank increased interest rates again with the lending rate increased by 0.18% to 7.02%, the fourth rate increase for the year.

Given the pressure for a tighter monetary policy, the net trend is still likely to be for a stronger Chinese yuan even though volatility levels liable to increase.