Weekly Forex Currency Review 28-10-2011

The EU Summit has managed to ease immediate threats surrounding the Euro-zone debt crisis and improved risk appetite which will undermine short-term defensive demand for the US currency.  There are still very important vulnerabilities surrounding the Euro-zone and the global economy as a whole and tensions could intensify again quickly given the debt dynamics and political pressures.

Key events for the forthcoming week

Market analysis

Dollar: 

The US data as a whole continues to suggest that the economy is achieving a path of weak growth, but there will certainly be fears over the consumer spending outlook, especially with confidence extremely weak.  There is no possibility of the Federal Reserve tightening policy and there will be further speculation that another round of quantitative easing could be announced. The dollar, therefore, remains in a weak position to gain on yield grounds, although the valuation issue is certainly more supportive.  Degrees of risk appetite and defensive demand will remain very important in the short-term and an easing of fear surrounding the Euro-zone will curb US currency demand.  There will still be fears surrounding the global economy which should provide some dollar protection.

The dollar was subjected to substantial selling pressure during the week as a whole as defensive demand for the US currency dipped amid an improvement in risk appetite.

The US economic data was mixed over the week and did little to inspire confidence.  Consumer confidence dipped sharply to 39.8 for October from 46.4 the previous month. This was the lowest figure since March 2009 and increased fears that the economy was sliding back towards recession even though recent data had been slightly more encouraging. The headline US durable goods report was weaker than expected with a 0.8% monthly decline, although there was a core 1.7% increase.

Fed Governor Dudley maintained a generally dovish tone in comments on Monday, but he did not suggest immediate quantitative easing. Underlying speculation that there could be further Fed action did limit any support for the dollar with the FOMC policy meeting due next week

Subsequent data was slightly better than expected with third-quarter GDP growth of 2.5% from 1.3% previously while jobless claims fell slightly in the latest week to 402,000 from 404,000.  The data will help underpin confidence to some extent, but there will still be a high degree of unease over the US fundamentals and the dollar will remained dependent on defensive support to make headway, especially given the shift in yields.  This risk was illustrated by a sharp drop in overseas US Treasury bonds in the latest reporting period.

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The EU Summit has removed the threat of a short-term disorderly collapse in the Euro area with relief that there has been agreement surrounding a revised package for Greece. There will still be a high degree of unease over the situation, especially as details still have to be worked out. There was a similar feeling of relief following the July deal on Greece which disappeared very rapidly and confidence is again liable to fade quickly, especially if the economy continues to deteriorate. There will be strong pressure on the ECB to cut interest rates and political tensions could return extremely quickly to limit Euro support.

The Euro was subjected to choppy trading, but was able to secure strong net gains as fear declined and it pushed to a seven-week peak near 1.4250 against the dollar.

Following the first Summit meeting on Tuesday, markets were buffeted by rumours ahead of the second meeting. Volatility spiked on Tuesday as there were reports that the ECOFIN meeting also scheduled for Wednesday had been cancelled. There was some initial confusion with fears that the actual Summit scheduled for later on Wednesday had been postponed. Rumours of disagreement among key leaders pushed the Euro to lows close to 1.38 before a recovery.

In the event, leaders secured slightly more than had been expected  by markets. There was agreement to increase core capital ratios within European banks to 9% by 2012 while the EFSF fire-power would also be increased to around EUR1.0trn through leverage, although precise details had yet to be worked out.

There was some surprise and relief as leaders agreed on a notional ‘voluntary’ 50% restructuring of private-sector Greek debt while there would be a revised EUR130bnsecond loan package for Greece. The IIF agreed to the restructuring after being told that the alternative would be a full-scale hard default.

There was a further improvement in risk appetite following the EU Summit as equity markets rallied and there were particularly sharp gains for the banking sector. There was important relief that leaders had managed to stave-off the immediate threat of a Euro collapse which encouraged a closing of short positions.

There was still concern over the lack of detail in the plans and fundamental doubts will continue. The ECB remains concerned over the mechanisms for expanding the EFSF fire-power, fearing the implications of increased leverage and there will also be very important political doubts. There were doubts within Germany and there were also further protests within Greece as the implications of continued austerity with fears that recession conditions would continue.

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Although the latest economic data has been mixed, there will be fears surrounding the outlook, especially with a sharp decline in industrial production. There will be strong pressure on the government and Bank of Japan to take a more decisive stance on weakening the yen, especially as the additional quantitative easing has not had a significant impact. An easing of stresses surrounding the Euro area should lessen the risk of capital repatriation and defensive yen demand, but the currency has remained resilient at this stage and pressure for aggressive intervention will increase.

he yen resisted selling pressure against the dollar and challenged fresh record highs against the US currency with a move through the 76 level.

The Bank of Japan left interest rates on hold at a maximum of 0.10%. The central bank also expanded its asset-purchase programme to JPY55trn from JPY50trn previously in an 8-1 vote. The Finance Ministry voiced frustration over the yen’s valuation and blamed speculative pressures, but there was no immediate evidence of an aggressive plan to intervene.

The latest Japanese inflation data was in line with expectations. In contrast, there was a much weaker than expected reading for industrial production with a 4.0% decline in output after a 0.6% gain while there was a further decline in household spending.

There will certainly be Bank of Japan unease over the industrial data and  increased pressure for the Finance Ministry to resist further yen gains against the dollar. These concerns will persist even though the yen has weakened against the Euro.

Sterling:

There will be further concerns over the UK economy as underlying consumer spending is likely to remain under pressure given the substantial pressures on incomes. The Bank of England has clearly indicated that it will retain an aggressive policy of expansion even with inflation at elevated levels and real yields remain extremely unattractive. There will be some short-term relief surrounding the banking sector which should tend to lessen the threat of capital outflows, although the underlying position is liable to remain unstable and pressures could return quickly.

Sterling moves were dominated by global-market trends and risk appetite even though underlying sentiment towards the UK economy remained weak. Sterling weakened against the Euro, but pushed to six-week highs above 1.61 against the dollar.

The latest UK consumer confidence data recorded a decline to -32 for the latest month from -30 previously which was a 32-month low as sentiment remained weak. Although there was a slightly stronger reading for the latest CBI retail sales survey, it remained in negative territory at -11 from -15 previously and there were further doubts surrounding the spending outlook. The Bank of England is continuing to take a gloomy tone on prospects as incomes remain under pressure.

There was a better than expected current account figure with the quarterly deficit held to GBP2.0bn from a revised GBP4.1bn. Although the data is volatile, there was some optimism that the UK funding environment was not as bad as expected.

There was relief surrounding the UK banking sector following the EU Summit as there was a sharp gain in equity markets. There may be reduced fears surrounding the threat of capital flows out of the UK financial sector, at least in the short-term, although there will also be unease surrounding the medium-term outlook as European banks still have to raise substantial amounts of capital.

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The National Bank will remain determined to protect the minimum Euro level against the franc in the short-term, especially as the political and financial cost of failure would be extremely high. The franc’s traditional relationship with risk appetite and defensive demand has broken down which will increase the risk of erratic capital flows in the short-term.  The near-term data will be watched closely to assess whether pressure on the Swiss industrial sector has eased. For now, the National Bank should be able to contain the franc even though there will be a high degree of uncertainty over the medium-term outlook.

The dollar was unable to make any impression on the franc and dipped to lows below 0.86 while the Euro was also generally weaker against the Swiss currency despite wider gains on the crosses as the breakdown in traditional relationships continued.

National Bank President Hildebrand continued to warn that there would be decisive attempts to defend the 1.20 Euro minimum rate against the franc which discouraged aggressive franc buying as market uncertainty remained high.

Australian dollar:

The Australian dollar found support on dips towards the 1.02 level and advanced strongly over the second half as risk appetite improved and the US currency fell. Following the EU Summit, there were reduced fears surrounding the risk of EU disorder which improved, helping to trigger an AUD peak around the 1.0750 level.

As far as the domestic economy is concerned, there was a weaker than expected outcome for consumer inflation. Although the headline figure was in line with expectations, there was a lower than expected reading for core inflation of 0.3% which maintained the potential for a cut in interest rates.

Australian dollar volatility is likely to remain high and a substantial amount of favourable news has been priced in which will limit further buying support.

Canadian dollar:

The Canadian dollar initially hit resistance close to parity against the US dollar and dipped sharply to lows near 1.02. There was, however, a renewed advance in the currency later in the week as global risk appetite improved and there was heavy selling pressure on the US currency.

The Bank of Canada left interest rates on hold at 1.00% and there was a downgrading of growth forecasts for the next two years which initially undermined the currency, although underlying confidence in the fundamentals was still broadly firm.

The Canadian dollar will continue to be influenced strongly by trends in risk appetite and commodity prices and it will be difficult to advance far from current levels.

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The rupee found support in the 50 level against the dollar during the week and there was a significant strengthening over the second half. There was a sharp improvement in risk appetite following the EU Summit which boosted risk appetite and there was fresh demand for the local currency which allowed a rupee advance to the 49 area.

The Reserve Bank of India increased interest rates by a further 0.25% to 8.50% following the latest council meeting. The bank did, however, indicate that rates were at a peak which helped underpin sentiment in the domestic equity market.

There will be scope for a further measured recovery in the rupee as risk appetite remains firmer. There is still likely to be underlying caution which will limit gains.

Hong Kong dollar:

The Hong Kong dollar was broadly resilient during the first half of the week with the US currency unable to gain any traction despite a mood of caution. There was strong corporate demand for the Hong Kong dollar which provided important support.

There was a recovery in risk appetite following the EU Summit which helped push the currency to near 7.77 as immediate fears surrounding China’s economy also eased.

The Hong Kong dollar should remain resilient with speculation over a medium-term revaluation offering protection from any renewed fears surrounding China’s economy.

Chinese yuan:

The Chinese yuan held steady over the early part of the week and there were strong gains for the currency over the second half as it strengthened the most in two months as it advanced to beyond 6.33 against the US currency.

There was a decline in safe-haven demand for the US currency even though there was still solid currency demand from importers. The evidence suggested that the PBOC was again looking for gradual yuan gains.

A recovery in the flash PMI reading back to above 50 also increased support for the yuan and reduced fears over the impact of measured currency gains.

Doubts surrounding the Chinese economy are likely to increase again yuan volatility is also likely to remain higher despite PBOC determination to limit movement.