Weekly Forex Currency Review 26-10-2007

Overall strategy

In the short-term, the dollar will continue to be undermined by fears over a wider downturn in the economy and a lack of yield support with markets pressing for further Federal Reserve interest rate cuts. Given the deterioration priced in, there will be scope for dollar corrections stronger, but short-term rallies will quickly attract selling interest. Underlying pressure for stronger Asian currencies will persist.          

Key events for the forthcoming week

Dollar

The weak housing and industrial data will reinforce the lack of market confidence in the dollar and there will be continuing expectations of further Federal Reserve interest rate cuts. The forthcoming week could be very important for market sentiment with the latest employment data and Fed rate decision both due. The dollar will need an improvement in the yield structure and increased official support to overcome a growing lack of confidence. Rallies will tend to hit selling pressure due to underlying diversification away from the dollar, but there will be support on valuation grounds. 
      
The dollar weakened to record lows near 1.4350 after the weekend G7 meetings before strengthening sharply to 1.4125. The US currency was unable to sustain the gains and depreciated back to new record lows beyond 1.4370 on Friday with the dollar also trapped at 30-year lows on a trade-weighted basis.

The US data was generally weak with durable goods orders falling by a further 1.7% in September while the underlying increase was held to a weaker than expected 0.3%. The latest jobless claims data was also higher than expected at 331,000 for the latest reporting week, maintaining unease over labour-market trends.

The housing sector remained under pressure with existing home sales falling by a further 8.0% in September to give an annual rate of 5.04mn, the lowest rate since the current series started in 1999. There was a monthly recovery in new home sales, but this reflected a sharp downward revision to August's data.

Markets moved to price in fully a 0.25% Federal Reserve interest rate cut next week while there was increased speculation over a second successive 0.50% rate cut.

Investment bank Merrill Lynch moved to increase its bad-debt write-downs in the latest week while there were rumours of substantial AIG write-downs which renewed credit fears in the US and global markets.

At last weekend's G7 talks, the US administration appeared to reject European calls that there should be a stronger statement opposing further dollar weakness against the Euro. G7 repeated their call that excessive exchange rate volatility should be avoided.

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The latest Euro-zone PMI data will reinforce expectations of a significant slowdown in the economy. There is likely to be increased political pressure for Euro gains to be curbed while there will also be pressure for the ECB to switch to a less restrictive policy. The underlying fundamentals should still remain generally supportive for the Euro, especially with the ECB still on inflation alert. Markets will monitor any evidence of economic divergence within the Euro-zone.

The Euro retained a generally firm tone over the week with an advance against most major currencies, although there was a high degree of volatility against the yen.

Early in the week, the Euro suffered its steepest one-day fall against the dollar for 15 months as it dipped to test support levels. There were reports of strong sovereign Euro buying support on retreats which helped the currency regain ground.

The Euro-zone PMI index for the manufacturing sector weakened significantly for the second month running with a decline to 51.5 in October which was the lowest reading for 26 months. The services-sector PMI was more robust with a monthly increase.

Euro-zone industrial orders rose 0.3% in September to give a 5.1% annual increase. The German IFO index edged lower to 103.9 in October from 104.2 the previous month while the IFO institute was generally optimistic over economic trends. German consumer confidence weakened over the month.

Yen

The domestic fundamentals should remain of secondary importance in the short-term unless there is a clear signal that the Bank of Japan will sanction a near-term increase in interest rates and this looks unlikely. In the near term, the Japanese currency will remain strongly correlated with stock market moves and levels of risk tolerances. The net credit risks should limit selling pressure on the yen despite persistent retail selling interest. The underlying pressure for Chinese yuan gains will also tend to provide some underlying yen support.                     
                    
The yen traded within a 113.30 - 115.0 range against the dollar during the week and there was a increase in volatility against the Euro with the yen weakening on Friday.

The Japanese yen moves were correlated strongly with moves in global stock markets
The yen secured some support from a firmer tone in Asian currencies and persistent upward pressure on the Chinese yuan.

The Japanese corporate services prices index rose 1.4% in the year to September, but there was no significant shift in interest rate expectations. Core consumer prices fell 0.1% in the year to September while industrial production fell 1.4% over the month.

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There has been little major economic data over the past week, but the weaker CBI survey, together with a drop in mortgage advances, will reinforce expectations of a slowdown in the economy. The Bank of England may still resist immediate pressure for a cut in rates, but there is still likely to be a reduction by early 2008 and evidence of a sharp deterioration in the housing sector would increase pressure for an early cut. The UK currency will also be influenced by global risk conditions and sustained credit-related stresses would tend to undermine the UK currency.                    
 
Sterling was unable to sustain levels stronger than 0.6950 against the Euro. The UK currency found support below the 2.03 level against the dollar and climbed back to challenge levels above 2.05 as the US currency came under renewed selling pressure.

The latest data recorded a slowdown in the housing sector with a drop in BBA mortgage approvals to 52,700 in September from 61,100 the previous month while overall mortgage lending also dropped.

The CBI survey recorded a significant deterioration with the orders component weakening to -6 in October from +6 the previous month. Export orders were weak while business confidence fell to a 20-month low.

MPC member Barker expressed caution over the immediate need for lower interest rates. The Bank of England, however, issued a cautious statement by pointing to commercial and financial-sector vulnerability to shocks. Markets continued to price in a rate cut within the next few months.

Sterling moves remained correlated with global stock market moves and levels of risk aversion with choppy trading against the dollar.

Swiss franc

The short-term Swiss franc moves will tend to remain correlated with global stock market moves and degrees of risk aversion. The net risks suggest that the Swiss currency should secure important underlying support. The domestic fundamentals will also remain sound and the National Bank will still consider an increase in interest rates in December. Given the underlying situation, the Swiss franc is unlikely to come under strong selling pressure.        
 
The Swiss currency found support close to 1.68 against the Euro, but struggled to make strong headway. The franc tested levels stronger than 1.1650 against the dollar after a brief US currency rally stalled below 1.18.

Producer prices fell 0.3% in September which cut the annual increase to 2.4% which eased inflation fears to some extent

National Bank member Hildebrand stated that there would be some negative credit-market impact on the Swiss economy, although he was still generally optimistic.

Hildebrand also stated that policy would be reconsidered if currency levels posed a threat to price stability and the Euro levels will be monitored closely.

The Swiss currency drew some support from the general lack of confidence in stock markets, although the impact was measured as emerging markets held firm.

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The Australian dollar found support close to the 0.8750 level against the US currency and pushed back to highs around 0.9130 late in the week as the dollar crumbled.

The headline consumer inflation rate was held to 0.7% in the third quarter with an annual rate of 1.9%. The underlying rate was higher than expected with a 2.9% annual increase, close to the 3.0% Reserve Bank ceiling.

There was increased speculation over a Reserve Bank interest rate increase at the November central bank meeting with markets estimating an 80% chance of a hike.

The Australian dollar drew support from high commodity prices, but the currency was still unsettled at times by increases in risk aversion.

In the near term, strong yield support will battle with an increase in risk aversion for supremacy with the markets attempting to secure further gains.

Canadian dollar

The Canadian dollar resisted pressure for a correction against the US currency and challenged 31-year highs as the US dollar came under wider selling pressure. The Canadian currency was again supported by the high level of oil prices.

The headline retail sales data was stronger than expected at 0.7%, although the underlying data was close to expectations.

Bank of Canada Governor Dodge stated that the currency gains had been abnormally rapid, although there was no evidence of intervention.

There will still be pressure for an underlying correction weaker after recent rapid gains, especially as credit-related fears will remain an important background factor.

Indian rupee

The rupee recovered from last week's losses and strengthened towards the 39.55 level against the US dollar during the week.

There was evidence of stock market inflows even though investors were still cautious. Regulators confirmed that there would be tighter controls on unregistered investors but the market response was more composed than the previous week.

The rupee was stifled by further reports of central bank intervention during the week while the high level of oil prices also tended to undermine the Indian currency.

The generally firm tone for Asian currencies helped support the rupee, especially as the US dollar remained under wider selling pressure.

Rupee volatility is liable to remain higher in the short-term and there is still the risk of a sharp correction weaker. 

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The Hong Kong dollar strengthened to the 7.75 level during the week, the first time this level had been reached since the lower band was put in place in May 2005. The HKMA intervened to sell HK$775mn on two occasions to prevent the local currency breaching the band limit.

Market interest rates remained high which provided support to the local currency, especially with a further reversal of arbitrage positions.

The Hong Kong currency was also supported by a further strong inflows to the local stock market as investor confidence remained very high.

The Hong Kong dollar should remain firm in the short-term on capital inflows, but a realignment of the currency band will be required to allow further gains. Volatility is liable to increase as capital flows may be unstable.

Chinese yuan

The Chinese yuan secured a firmer tone during the week and the central bank tolerated gains through the 7.50 level against the dollar for the first time since the 2005 float. The yuan strengthened to highs around 7.48. The trade-weighted index did not strengthen significantly as the US currency was generally weak

The domestic economic data remained strong with an 11.5% increase in the year to the third quarter. Market interest rates jumped higher during the week which helped support the yuan.

At the Washington meetings, G7 member countries continued to push hard for the yuan to be given greater flexibility and allowed to strengthen more rapidly. Chinese authorities stated that the market would be given a stronger role.

There will be further underlying pressure for a stronger yuan while international political pressure will also continue. The most likely outcome is for a further slow advance, although there is certainly a significant chance that a one-off revaluation will be sanctioned.