Weekly Forex Currency Review 27-07-2012

Policy responses to the Euro-zone structural crisis and evidence of sharp slowdown in the global economy will be extremely important. The ECB will be under pressure to expand monetary policy and there will also be speculation over additional Fed action. It will still be very difficult for the global policy-makers to sustain an improvement in risk appetite and the net impact is still likely to be for a weaker Euro over the medium term.

Key events for the forthcoming week

Dollar:

The US economic data has maintained a generally weaker tone with a series of weaker business surveys and expectations that the housing sector was also at risk of stalling. Federal Reserve policies will remain very important and there will still be expectations of further measures to boost monetary policy further if there is evidence of further economic deterioration.  International considerations will also remain extremely important and, although there has been some easing of immediate dollar demand, net capital flows should still provide important support for the US currency as central bank flows remains supportive.

The dollar failed to hold its best levels over the week and dipped sharply over the second half with losses against the Euro and commodity currencies as defensive demand eased slightly.
 
There was a sharp decline in the latest US Richmond Fed index which reinforced fears surrounding a slowdown in the economy as business surveys remain mixed.

There were mixed US economic reports as jobless claims fell to 353,000 in the latest week from 386,000 previously while there was a headline 1.6% increase in durable goods orders. In contrast, there was a decline in core orders which maintained unease over the underlying investment trends. There was also a small decline in pending home sales according to the latest release.  

There were still expectations that the Fed would move to additional quantitative easing which stemmed dollar demand ahead of next week’s FOMC meeting.

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The Euro-zone crisis will continue to dominate in the short-term.  There will be major fears surrounding the Spanish outlook with increasing unease surrounding Italy and expectations that Greece will leave the Euro area. The ECB comments increased speculation over aggressive action, potentially including quantitative easing.  There will still be major economic and political opposition to unorthodox policies within Germany. It is also the case that any aggressive monetary policy action would tend to undermine the Euro even if the Euro structure can be broadly sustained. In this environment, the Euro will find it difficult to sustain any relief rallies.

After hitting fresh two-year lows, there was a sharp corrective Euro rally back to the 1.23 area on Thursday. As far as the economic data is concerned, there was a third successive decline in the German IFO index to 103.3 for July from 105.2 previously as conditions continued to deteriorate, although this was not an extremely low figure in an historic context. The manufacturing PMI index also dipped to a three-year low.
 
The IMF-led troika started their visit to Greece and the underlying tone from officials was generally negative with one EU official describing Greece as being pretty terrible, increasing speculation that Greece would effectively be pushed out of the Euro. A research report from Citibank also stated that the chances of Greece leaving the Euro-zone were now around 90% on a 12-month view.

Spanish officials denied that the country was on the point of requesting a sovereign bailout and these comments were later repeated by a German Finance Ministry spokesman. The comments helped alleviate the immediate sense of panic surrounding Spanish markets as bond yields declined from record highs above 7.7%.

There were also comments from ECB member Nowotny who suggested the possibility of accelerated moves to granting the ESM a banking licence. Such a move would allow the ESM to buy government bonds in the secondary market.  

The trigger for the Euro’s advance were comments from ECB Chairman Draghi in a pre-Olympic London investment conference.  The ECB chief stated that the bank would take whatever it takes to protect the Euro and in forceful comments he stated that ‘ believe me, it will be enough’. Potentially the most important part of the remarks were comments that if borrowing costs hampered the transmission of monetary policy then this would come under the bank’s mandate. This suggested that the bank would consider some form of quantitative easing in the form of bond buying or a resurrection of the dormant SMP to drag peripheral bond yields lower.

Market optimism that the ECB would take action triggered a sharp decline in Spanish and Italian bond yields. The benchmark Spanish yields fell back to below the 7.0% level as yield spreads over bunds also narrowed sharply.  The IMF is due to announce its latest report on Spain on Friday and sentiment could deteriorate again rapidly.  

Yen: 

Unease over the global economy will tend to support defensive capital inflows into the Japanese currency, especially with continuing fears surrounding the Euro-zone outlook.  With consumer prices still declining, there will be additional pressure for further monetary easing by the Bank of Japan. Regional competitiveness factors will also be extremely important with pressure for yen gains to be resisted, especially if the Chinese yuan weakens. The yen is still likely to resist aggressive selling given global influences.     

The dollar found support in the 78 area against the yen while rallies quickly stalled in the 78.30 area after a brief surge following a media report that Japan was moving closer to intervention to weaken the currency.

Deputy Bank of Japan Governor Yamaguchi warned that there would be a further policy easing if yen strength threatened the recovery.  The Chinese yuan continued to edge weaker as it hit a 2012 low against the US currency. A weaker yuan would increase competitiveness issues and intensify pressure for yen gains to be resisted.

Domestically, the latest inflation data was weaker than expected with national core consumer prices falling by 0.2% in the year to June while Tokyo prices fell 0.8%. The trend for falling prices will increase speculation of further Bank of Japan action to relax monetary policy. The yen also edged weaker following gains for regional bourses, although the gains were broadly limited.

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There will be further concerns surrounding the UK growth prospects, especially after the much weaker than expected GDP data for the second quarter. There will be additional pressure for more aggressive Bank of England action to provide support and there will also be pressure for a shift in fiscal policy. The AAA credit rating will be an important factor with greater speculation that it could be lost which would also jeopardise defensive capital inflows.  Overall, Sterling will find it difficult to make sustained progress given the fundamentals.

Sterling found support on dips towards the 1.5450 level against the US currency and rallied firmly to a peak close to 1.57. Sterling was unable to hold gains beyond 0.78 against the Euro.
 
The latest GDP release was much weaker than expected with a reported 0.7% decline for the flash second-quarter estimate.  This was the third successive quarterly contraction with the economy undermined by a further sharp decline in construction as industrial output also weakened.  There was some recovery in the latest services-sector output with a 0.5% gain in the three months to May.

The latest mortgage lending data was significantly weaker than expected for June with BBA approvals of 26,300 from 29,600 previously which increased unease over bank lending trends and the outlook for consumer spending.  

The weak data will undermine confidence and lead to speculation over further Bank of England easing measures, potentially including an interest rate cut. There will also be increased fears that the UK AAA rating will be cut which would undermine the potential for capital inflows. There will also be additional political stresses with the Chancellor in particular under intense pressure.

There was further speculation that the UK AAA rating would be in jeopardy following the much weaker than expected GDP data release on Wednesday. Although the immediate market impact was limited, there will be the threat of a reduction in capital inflows into Sterling as institutional flows decline.

Swiss franc:

With confidence in the Euro-zone outlook remaining extremely weak, defensive flows into the Swiss currency are likely to continue. The National Bank will still be forced to defend the minimum Euro level on a daily basis and if pressure increases further there will be strong demands for the bank to consider capital controls or negative official interest rates. For now, the central bank is likely to stand firm and resist pressure for the Euro minimum to be abandoned.

The dollar hit resistance above 0.9950 against the US dollar and dipped sharply to lows below 0.9750 before staging a slight recovery.  Despite a strong Euro advance against the dollar it was trapped close to the 1.2010 level against the Swiss currency.

National Bank Chairman Jordan reiterated the determination to maintain the 1.20 minimum Euro level and also stated that it was theoretically possible for currency reserves to rise without limit. Markets will, however, be less confident that the bank’s nerve will hold if there is an intensification in capital flows from the Euro area.

Any alleviation of stresses surrounding the Euro-zone and more aggressive policy easing by the ECB could ease immediate pressure on the 1.20 minimum level. There were no initial signs that capital inflows had eased which will maintain pressure on the National Bank as reserves continue to rise rapidly.

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The Australian dollar found support on dips to below 1.02 against the US currency during the week and rallied firmly to a peak above 1.04. Trends in risk appetite continued to dominate markets and there was a strong boost in confidence following ECB Chairman Draghi’s comments that everything would be done to save the Euro.

There was a rebound in global equity markets and a generally weaker US currency which underpinned the Australian currency. The domestic influences were limited with a slightly weaker than expected inflation reading for the second quarter.

The Australian dollar will find it difficult to sustain any further gains, especially given unease surrounding domestic and regional growth trends.

Canadian dollar:

The Canadian currency found support on dips beyond 1.02 against the US currency during the week and pushed to a high around 1.0050 as oil and commodity prices rallied.  There was a stronger than expected reading for retail sales, although international considerations tended to dominate.

Although there were some underlying concerns surrounding debt levels and housing, this was overshadowed by a lack of confidence in fundamentals elsewhere.

Concerns surrounding the global economy and commodity-price trends will tend to limit scope for Canadian dollar gains even if there is a near-term solid tone.

Indian rupee:

The rupee found support beyond 56 against the US dollar during the week and pushed to a high in the 55.5 region. There was a relief rally in risk conditions late in the week as the Euro rallied which helped support the rupee.

There was also a slightly greater degree of confidence surrounding the domestic fundamentals as markets waited for the latest GDP data. There was still an underlying mood of caution, especially with further concerns surrounding a slowdown in the regional and global economy.  

Persistent doubts surrounding the regional economy will still tend to limit the scope for rupee gains even if domestic confidence and reform optimism is sustained.

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The Hong Kong dollar was confined to narrow ranges during the week, but there was support close to the 7.76 level as the currency was blocked in the 7.7550 area.

The currency failed to gain much support from an improvement in risk appetite as there were still important concerns surrounding the Chinese economy with a weaker Chinese yuan also curbing any Hong Kong dollar support.

Uncertainty surrounding the Chinese outlook should prevent serious near-term pressure on the peg with narrow ranges likely to persist for now.  

Chinese yuan:

The Chinese yuan maintained a weaker tone for much of the week and dipped to 2012 lows beyond 6.38 against the US currency. The PBOC was content to let the yuan weaken as it set a series of lower fixes. There was a modest reversal later in the week following the strong Euro rally.

There were still major concerns surrounding the Chinese economic outlook with expectations of weakening demand. There were still expectations of further cuts in reserve ratio requirements which dampened currency support, especially with the Shanghai bourse near 2012 lows and with a continuing threat of capital outflows.

The IMF stated that the yuan was now only slightly undervalued, pulling back from calls for sharp appreciation.

The yuan is likely to be subjected to underlying selling pressure given a developing dollar shortage given unease over the growth outlook and slowdown in exports.

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