Weekly Forex Currency Review 25-01-2008

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Overall strategy: The dollar will remain very vulnerable on yield grounds following the aggressive Fed stance on interest rates with doubts whether the move was justified. Markets will, however, also be looking for pro-growth policies which will provide some US currency protection. Conditions will remain very tense, but a near-term peak in fear should now have been passed which will lessen immediate pressure for an unwinding of carry trades.                     

Key events for the forthcoming week

Dollar:

There will be further US recession fears, especially if consumer spending appears to be weakening sharply. The aggressive Federal Reserve stance on interest rates has also severely undermined US yield support. The situation will, however, be complicated by the increased fears over the global economy. In this context, some dollar protection on defensive grounds is still realistic while markets will also tend to reward central banks who take a pro-active policy to support growth. The dollar will still find it difficult to make more than limited headway.   
      
The dollar was again subjected to high volatility over the week. The US dollar strengthened to highs near 1.4350 against the Euro before weakening to lows beyond 1.4750 as intra-day volatility remained at elevated levels.

The dollar gained support when global stock markets weakened sharply even though fears were triggered to a considerable extent by fears over the US economy. As these fears eased, the dollar encountered significant selling pressure.

The Federal Reserve held an emergency meeting ahead of the scheduled January meeting and announced a 0.75% cut in the Fed funds rate to 3.50%. The Fed also cut the discount rate by 0.75%. Regional Fed President Poole voted against the interest rate move with concerns that it was not justified ahead of next week's meeting.

Even with an aggressive cut, markets were still pricing in the potential for a further cut in rates at the regular January 30th FOMC meeting.

There were plans to support the US bond insurers following warnings that their credit ratings could be downgraded. The administration also proposed a fiscal support package of around US$150bn including tax rebates.

Jobless claims were again below expectations in the latest reporting week at 301,000 from a revised 302,000 the previous week. Existing home sales edged slightly lower to an annual rate of 4.89mn in December from 5.00mn previously. Inventory levels fell over the month back to below 10 months supply while prices were little changed.

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There will be increased fears over the growth trends within the Euro-zone economy. The ECB will want to retain a tough stance on interest rates in the short-term, especially as there are still important inflation fears. The central bank will, however, be under strong pressure to cut interest rates if there is evidence of serious economic deterioration and there is a much greater risk of divisions within the central bank. Overall market confidence in the Euro-zone economy is liable to weaken which will limit the scope for Euro gains.         

The Euro has fluctuated sharply over the week, in line with high volatility levels. The Euro weakened sharply against the dollar, yen and Swiss franc during the week, but subsequently recovered ground, especially against the Japanese yen and US dollar.

The IFO business confidence index was stronger than expected with an increase to 103.4 in January from 103.0 the previous month.

Despite the IFO survey, overall market confidence in the Euro-zone economy continue to weaken with increased expectations that the ECB would switch policy within the next few weeks. SocGen announced substantial fraud-related losses.

Comments from ECB officials were generally mixed with President Trichet stating that the bank would need to react to a crisis situation. Most ECB members still took a tough stance on inflation, especially from ECB member Weber which underpinned the currency. The Spanish Finance Minister stated that some members of the ECB were considering a cut in interest rates.

Yen:  

The Japanese economy will remain subdued in the short-term with domestic spending trends uninspiring while there will also be a slowdown in export growth. Yield support for the yen will remain weak and a recovery in risk appetite would undermine the currency. The yen will gain support on defensive grounds when risk aversion intensifies again, especially as there will be the risk of capital repatriation. There has been no significant opposition to yen gains so far, but there is likely to be resistance to sharp yen gains beyond 105.0.    
                    
The Japanese currency secured strong gains during the middle of the week with gains to 30-month highs of 105.0 against the US dollar while the currency also pushed to 5-month highs against the Euro before retreating sharply.

The yen moves were dominated by risk aversion levels and a rally in global equity markets helped reverse the gains later in the week with losses back to 107.5.

The Bank of Japan left interest rates on hold at 0.50% at the latest policy meeting. The central bank also downgraded its assessment of the economy in its monthly report. The core consumer prices rise of 0.8% in the year to December did not have a significant impact on interest rate expectations

There were no major protests against yen gains by senior Japanese finance officials during the week and there was no evidence of intervention, although there were some rumours that the central bank was checking prices near the 105.0 level.

The monthly Tankan confidence index weakened to a two-year low in the latest survey while the all-industries index fell over the month. The December trade surplus fell by 20% over the year as export growth slowed and oil imports remained elevated.

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Confidence in the UK economy will remain weak in the short-term with further expectations of a sharp slowdown in growth and fears over recession as the housing sector deteriorates. The Bank of England is likely to cut interest rates in February and will need to steer a fine course between growth and inflation fears with confidence remaining very fragile. The UK currency should gain some support from the degree of deterioration already priced in, but Sterling is unlikely to secure more than a limited recovery.   
 
Sterling was unable to make much impression on the Euro during the week and weakened to lows below 1.94 against the US currency before a recovery back to 1.9820 as the dollar stumbled and risk aversion eased.

The Bank of England minutes from the January  MPC meeting recorded a 8-1 vote for unchanged rates with Blanchflower voting for a 0.25% rate cut. The bank was more concerned over the inflation outlook and looking to wait for the inflation report.

Bank Governor King and MPC member Sentance both warned that the economy was facing a much more difficult period, but also pointed to the increased inflation risks.

Fourth-quarter GDP slowed to 0.6% from 0.7% previously, although this was slightly stronger than expected. Services-sector growth also slowed to 0.6% in the three months to December. The CBI industrial survey held steady in the latest monthly survey while there was a further drop in mortgage approvals to a 10-year low.
 
Swiss franc:

Short-term franc trends will remain strongly influenced by the extent of global risk aversion. There is some scope for markets to take a more measured stance in which will tend to curb short-term franc demand. The franc has, however, proved resilient which suggests that underlying demand for the currency will remain firm. The franc may will be vulnerable to more substantial selling pressure if there is evidence that the domestic indicators are deteriorating. Nevertheless, substantial franc losses look unlikely at this stage.            
 
The Swiss franc secured strong gains against major currencies during the week. The franc strengthened to test record highs against the US dollar and also advanced to highs around 1.5850 against the Euro which was the strongest level since late 2006.

The Swiss franc gained strongly when equity markets were subjected to heavy selling pressure and the currency was able to resist substantial selling pressure when global markets recovered. The franc partially reversed gains against the Euro.

Annual retail sales growth was below the 3.0% level for November, although the data was still solid in historic terms. Producer prices rose 3.0% in the year to December.

National Bank President Roth stated that he was still optimistic over the Swiss economy despite the increased US economic risks and stated that there was no urgent need to change interest rates.

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The Australian dollar weakened to lows near 0.85 against the dollar during the middle of the week. The currency moves were correlated strongly with degrees of risk aversion and the Australian dollar regained ground firmly to 0.8840 later in the week as global equity markets recovered strongly.

Domestically, the headline consumer price increase was slightly lower than expected for the fourth quarter at 0.9%. There was, however, a 1.0% increase in core prices which pushed the annual rate to a 16-year high of 3.4%.

The Reserve Bank comments were still robust on inflation and markets were still pricing in over a 50% chance that interest rates would be increased in February despite the increased global growth uncertainties and fears.

The Australian dollar will secure further support on yield grounds, especially as speculation over an interest rate increase will continue, but gains are liable to be limited from current levels.

Canadian dollar:

The Canadian dollar weakened to lows beyond the 1.03 level against the US currency during the week, but then rallied strongly back to near the parity level.

The Bank of Canada cut interest rates by 0.25% to 4.00% at the latest monetary policy meeting. The central bank comments also suggested that it would cut rates again with a further reduction realistic at the next meeting.

The retail sales data for November was stronger than expected with a 0.7% monthly increase while core sales rose 1.7% over the month.

The Canadian dollar was unsettled over the first half of the week by a drop in oil and commodity prices. The currency moves were also influenced strongly by the shifts in global equity prices with a significant Canadian recovery when markets rallied.

The Canadian dollar will struggle to make strong headway much beyond parity in the short-term, especially with the Bank of Canada looking to cut interest rates again.

Indian rupee:

The Indian rupee dipped sharply early in the week as there was a sharp drop in global equity prices. The Indian currency weakened to lows near 39.80 against the dollar.

A stabilisation in global equity markets helped support the rupee with a move back towards 39.40, although the evidence did not suggest strong capital inflows after outflows of over US$2.5bn over the previous week as caution prevailed.

The rupee gained support from the US interest rate cut, although the impact was offset by reports that the Indian central bank would cut interest rates late in January.

Despite a near-term recovery, the net global risks suggest that the Indian currency is liable to weaken during the next few weeks. Losses should be measured unless there are severe stresses on emerging markets.

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The Hong Kong dollar was confined to relatively narrow ranges during the week despite the intense volatility in major asset prices. The currency settled close to the 7.8080 level as the large asset-price swings tended to discourage arbitrage activity.

The HKMA cut local interest rates to mach the US Federal Reserve move which curbed immediate local currency support as inter-bank rates remained at low levels.

The consumer inflation rate rose to 3.8% in December from 3.4% the previous month, but there was no evidence of serious HKMA alarm over the situation.

The Hong Kong dollar is likely to find further support close to the 7.81 level against the US currency as arbitrage activity will fade above this level.

Chinese yuan:

The Chinese yuan has remained strong over the past week and pushed to new record highs against the dollar at just stronger than 7.21 on Friday. Futures markets continued to price in a faster rate of appreciation as yield support increased.

The inflation concern persisted as the December annual inflation rate was 6.5%, although this was close to market expectations. A senior Chinese official reported that yuan appreciation should be speeded up to help curb inflation pressures.

GDP growth was 11.4% for 2007 as a whole despite some evidence of a slowdown in the fourth quarter.

The underlying pressures for Chinese yuan appreciation will continue in the medium term and the central bank should be content to let the currency advance further.