Weekly Forex Currency Review 27-07-2007

Overall strategy

Levels of risk tolerances are likely to remain very important in the short-term as markets remain fearful over the US and global implications of sub-prime difficulties. The overall tightening of credit and liquidity should provide important support to the Yen and Swiss franc despite retail selling interest when these currencies strengthen. The dollar will secure some protection as confidence in other G7 countries is liable to falters to some extent, but strong gains are unlikely. 

Key events for the forthcoming week

Dollar

There will be further concerns that mortgage-related difficulties will undermine the US economy, especially with weak housing data. The labour-market has remained firm and this will help underpin confidence, although there will still be speculation over a Federal Reserve interest rate cut late in 2007. The dollar will gain some protection from an increase in risk aversion and a shift away from emerging markets, particularly in view of the high US market liquidity. Any escalation in European growth concerns would also tend to support the US currency against the Euro. Dollar recoveries will, however, remain limited. 
      
The dollar fell to record lows against the Euro in the middle of the week and the trade-weighted index fell to a 15-year low before a fragile recovery in choppy trading as global volatility increased. Higher risk aversion and emerging-market stresses increased defensive demand for the dollar.

There were further concerns over the US mortgage sector during the week, illustrated by the earnings warnings from Countrywide Financial and weak data

US existing home sales fell to an annual rate of 5.75mn in June, a monthly drop of 3.8%, which was the lowest figure since November 2002. The new home sales data was also weak with a 6.6% drop to 834,000 for June as inventories held steady while prices were firm.

The durable goods orders data was disappointing with a 1.4% monthly increase for June while underlying orders fell for the second month. The labour-market data remained more encouraging with jobless claims held at 301,000 in the latest week.

The Fed's Beige Book reported that there was moderate growth in most districts while cost increases were continuing and the labour market remained tight.

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There is likely to be increased speculation over a slowdown in Euro-zone growth rates, especially with the risk that other economies will under-perform Germany given the deterioration in competitiveness. The impact will be measured while expectations of further ECB interest rate increases are sustained, but the Euro will be much more vulnerable if there are suggestions that rates will not be increased within the next two months.           

The Euro pushed higher in the first half of the week, but weakened significantly over the second half of the week due in part to heavy profit taking on the Euro crosses as carry trades were unwound. The sharp losses in European equity markets also unsettled the Euro to some extent with a retreat to 1.37 against the dollar from highs of 1.3850.

The Euro-zone survey evidence was weaker over the week. The July German IFO index fell to 106.4 from 107.0 the previous month while Belgian business confidence also weakened slightly over the month.

There were increase fears over sub-prime fears at European banks which undermined the Euro slightly, especially as Standard & Poor's downgraded some European bonds

Yen

The underlying economic trends are liable to remain uninspiring in the short-term, although steady growth is realistic.  The most likely outcome is that the Bank of Japan will increase interest rates at the August meeting, although it is by no means a certainty.  Carry trade trends will remain a very important influence and a general increase in risk aversion would encourage a further closing of positions funded through the Japanese currency. These risks will increase sharply if there is sustained capital repatriation back to Japan as retail yen selling could reverse rapidly. The main feature is likely to be increased volatility.            
                    
After losses during the first half of the week, there were sharp yen gains with the currency strengthening to highs near 118.00 against the dollar and 162.50 against the Euro.

The yen gained support from an increase in risk aversion during the week. Markets were less confident that sub-prime difficulties would be contained within the US market and this resulted in a wider reassessment of risk and a reduction in carry trades as global stock markets fell.

The latest capital account data recorded a weekly surplus with firm inflows into Japanese markets while there was a net flow of funds back to Japan.

Bank of Japan member Noda stated that the bank would need to be convinced over growth and inflation trends before increasing interest rates while there were also warnings over the possibility of a rapid unwinding of carry trades.

The trade position remained strong for June with a JPY1.23trn surplus for June as exports rose strongly.

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There is likely to be increased speculation over a slowdown in the US economy with a particular focus on the retail sector. There is also the potential for a downgrading of interest rate expectations. The Sterling impact will still be measured while markets are expecting rates to increase to 6.0%, but the effect will be much large if it appears that UK rates have already peaked. The UK currency will also tend to weaken if there is a sustained reduction in carry trades and will be at risk of at least a limited further correction weaker.          
 
Sterling pushed to highs near 2.0650 against the dollar early in the week before a rapid retreat to 2.0400 as rising risk aversion triggered an unwinding of carry trades. The UK currency held firm against the Euro and also proved more resilient to selling pressure than other high-yield currencies.

There was little in the way of major economic data released during the week, but the releases had a softer tone.

The latest CBI industrial survey reported a decline in orders to -6 from +8 the previous month, the lowest figure since January, with the other components also weaker

The Nationwide Bank reported that house prices rose just 0.1% in July, the lowest monthly increase of the year while there was a drop in monthly mortgage approvals.

Bank of England deputy Governor Gieve stated that the bank should  be cautious over raising interest rates when there were uncertainties over the economic direction.

Swiss franc

The global economic trends are liable to dominate in the short-term and the Swiss currency will be in a position to benefit if there is a sustained increase in risk aversion. Although the franc could be seen as an alternative to the yen as a funding currency, the net capital account trends are likely to be more favourable for the currency. The Swiss franc will gain support from robust fundamentals with the National Bank set to increase interest rates in September and net gains remain realistic.
 
The Swiss currency remained on the defensive over the first half of the week and weakened to lows near 1.6660 against the Euro before strengthening sharply to 1.6530 on Thursday. The franc weakened to 1.2160 against the dollar before a recovery to highs around 1.2025 in choppy trading.

There was little in the way of fresh information on the Swiss economy during the week.

The Swiss currency struggled to gain support from increased risk aversion during the first half of the week. The announcement of a postponed loan issue from Chrysler helped trigger a reassessment of the situation with franc gains amplified by sharp drops in global stock markets during Thursday.

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The Australian dollar secured support from high commodity prices and yield considerations during the first half of the week. There were gains to highs of 0.8870 against the US dollar before a sharp dip to lows of 0.8560 in very choppy trading as global stock markets weakened sharply and risk aversion increased.

Consumer prices rose 1.2% in the second quarter compared with expectations of a 1.0% increase. Although the headline annual inflation rate fell to 2.1%, the core rate increased to 2.7%. Markets moved to increase the chances of an August interest rate increase to around 80% following the inflation data.

Reports of difficulties in Australian hedge funds and delays in bond issues undermined Australian dollar confidence later in the week.

The Australian currency will be supported by expectations of higher interest rates. The net effect of rising risk aversion is likely to be for a weaker currency, especially with reduced capital inflows from Japan, and volatility will remain higher.

Canadian dollar

Canadian dollar volatility was high during the week, especially on Thursday. The currency strengthened to 1.0350 against the US currency before a sharp retreat to 1.0600.

The Canadian retail sales data was much stronger than expected with a 2.8% increase for May while core sales rose 2.3% over the month. The Canadian currency drew support from the high level of oil prices during the week.

The currency was, however, undermined by a sharp drop in risk aversion with a reversal in speculative inflows which had been funded through the yen.

Canadian dollar volatility is liable to remain higher in the short-term. Underlying sentiment is likely should remain firm which will limit any further losses triggered by an unwinding of carry trades.

Indian rupee

The Indian rupee was trapped in relatively narrow ranges for much of the week and was holding close to 40.30 on Thursday after a nine-year high close to 40.20 with investment flows still firm.

There were, however, concerns over the trend in global stock markets and this undermined rupee demand late in the week. The currency also dipped sharply on Friday to 40.50 as regional stock markets fell heavily.

Initially, there was evidence of further Reserve Bank intervention to curb rupee gains while the high level of oil prices was a negative factor for the Indian currency.

Rupee sentiment is liable to be slightly weaker in the short-term with fears that higher global risk aversion will trigger an outflow of funds from local markets. Losses in the short-term should remain limited unless regional stock markets continue to fall rapidly.

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The Hong Kong dollar drifted weaker to the 7.8220 level against the US dollar before strengthening back towards the 7.82 level late in the week.

The Hong Kong dollar gained some support from lower US yields during the week. As Asian currency markets fell sharply on Friday, the Hong Kong currency also gained some backing as a regional safe haven with high liquidity levels.

There was also some speculation that Hong Kong inflation would rise which would tend to put upward pressure on local interest rates.

The Hong Kong dollar should find further support weaker than the 7.8220 level against the US currency, although volatility could increase significantly if regional stock market tensions persist.

Chinese yuan

The Chinese yuan pushed to fresh post-revaluation highs around 7.554 against the dollar on Wednesday before weakening slightly to around 7.563 on Friday.

US Treasury Secretary Paulson is due to visit China next week to discuss trade and currency issues and there was speculation that the central bank would allow the yuan to strengthen at a faster pace next week.

The US Senate Finance Committee also approved legislation that would exert pressure for a faster pace of Chinese yuan appreciation and impose sanctions if currencies are not allowed to strengthen, maintaining underlying pressure for yuan appreciation

The Chinese currency gained some support from Japanese yen gains over the second half of the week

The underlying trend should continue to be for a stronger Chinese yuan and a one-off revaluation remains a significant possibility which could push the yuan through 7.50 against the US dollar. The daily moves are liable to be higher given global asset-price fluctuations.