Weekly Forex Currency Review 29-06-2007

Overall strategy

Investor sentiment towards carry trades and high-yield currencies will continue to fluctuate and portfolio shifts at the start of the third quarter will be important. The net global credit tightening will make it difficult for high-yield currencies to sustain gains from current levels with the risk of a sharp corrective retreat.

Dollar

The latest US economic data has raised some doubts over the growth prospects and there will be further uncertainties over the impact of mortgage difficulties. The Federal Reserve is likely to maintain a steady policy in the short-term and the dollar should be able to resist heavy selling pressure. The US currency should also gain some support if there is a sustained increase in risk aversion with a defensive flow of funds back to US Treasuries. There will be important structural weaknesses which curb the potential for substantial dollar gains.       

The dollar struggled to find direction over week with little change against the Euro as narrow ranges prevailed with the dollar unable to strengthen through the 1.34 level.

The Fed left interest rates on hold at 5.25% at the latest FOMC meeting and, in the statement accompanying the decision, the Fed stated that core inflation had improved modestly. Members stated that the predominant risk was still that inflation does not moderate as expected while the US growth outlook was upgraded.

The US economic data generally failed to provide clear direction over the week. US first-quarter GDP was revised up marginally to an annualised rate of 0.7% from 0.6% while the core PCE inflation indicator was higher than expected.

US existing home sales were little changed in May while new home sales corrected weaker from the sharp increase seen last month.

Jobless claims fell to 313,000 in the latest week from 324,000 previously while there was a 2.8% drop in durable goods orders and consumer confidence weakened for June.

Markets moved to price in the possibility of a rate cut late in 2007, but there was little conviction in the move as uncertainty prevailed.

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The Euro-zone economic data should hold relatively firm in the short-term despite some concerns over the consumer spending outlook and the ECB will retain a tightening bias for interest rates. Given this combination, the Euro should remain firm at this stage. There will, however, be the threat of a more pronounced slowdown in growth and pressure for interest rate increases to be suspended is liable to increase later in the third quarter.       

The Euro retreated from best levels against most major currencies during the past seven days. Ranges were relatively narrow against most currencies despite some sharp fluctuations against the yen.

The Euro/yen moves reflected the fact that carry trades continued to dominate markets. German unemployment fell by over 30,000 in May, resuming the decline seen for most of the last six months, and consumer confidence increased to a six-month high.

Money supply growth was strong in the latest monthly data. The ECB continued to take a firm stance on policy and suggested that it would look for a further increase in interest rates during the third quarter.

Yen 

Yield considerations will remain negative for the Japanese yen in the short-term which will encourage capital outflows and initial yen selling, especially with subdued inflation data. The Bank of Japan is likely to increase interest rates in August and the authorities appear less willing to tolerate further yen weakness. Increased risk aversion, coupled with tighter credit, will tend to support the yen and there is still the possibility of a sharp and disruptive market correction.         
                    
The yen found support weaker than 124.0 against the dollar and strengthened to highs near 122.0. The yen failed to sustain the gains with weakness resuming later in the week.

The industrial production data was worse than expected with a 0.4% decline for May and this raised some concern over the Tankan index due next week, especially as capital spending indicators have been mixed over the past two weeks.

Consumer prices fell 0.1% in the year to May while Tokyo inflation indicators were also subdued which dampened expectations over Bank of Japan tightening. There was, however, a stronger report for retail sales over the month while the unemployment rate held at 3.8%.

Top finance official Watanabe has been replaced by Shinohara and this increased speculation that the Japanese authorities would take a firmer stance and resist further yen losses.

There were further warnings over yen weakness and the risks of a sharp reversal in carry trades from international organisations such as the IMF and BIS.

There was some evidence that Japanese funds were curbing the flow of new capital into investment trusts which specialise in buying overseas currencies.

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There is a strong possibility that the Bank of England will increase interest rates again at the July meeting and an increase would maintain short-term Sterling support. The economy is, however, liable to slow and markets have already priced in rates increasing to at least 6.0% which will make it difficult for the UK currency to secure firm buying. Any sustained reduction in carry trades would also be likely to undermine the currency.       
 
Sterling pushed back above the 2.00 level against the dollar during the week and
the trade-weighted index rose to the highest level since February as sentiment remained firm.

There was little in the way of major UK economic data during the week. There was some evidence of an underlying slowdown in mortgage lending and the June CBI retail sales survey was weaker, but house prices registered another firm increase for June with a 1.1% monthly increase according to the latest Nationwide survey.

There were mixed comments from Bank of England officials over inflation in testimony to parliament. The net balance of comments suggested that there would be a split vote at the July MPC meeting, but that the majority was leaning towards an increase in rates.

Swiss franc

The economy will remain robust in the short-term and will justify a further increase in interest rates. The National Bank is also concerned over the inflationary impact of franc weakness which will increase the possibility of a more aggressive monetary tightening. The central bank will also maintain verbal intervention against further currency weakness. As global credit conditions tighten, the net impact is likely to be a stronger Swiss currency even with the possibility of short-term selling associated with carry trades.
 
The Swiss franc was unable to sustain gains through the 1.65 level against the Euro and fluctuated close to 1.23 against the dollar for much of the time.

The Swiss currency gained some support from increased risk aversion in the middle of the week, but conditions then stabilised with a recovery in global stock markets curbing franc gains.

The KOF leading index rose to 1.98 in June from a revised 1.94 in May which continued to suggest firm growth in the economy.

The National Bank continued to warn that interest rates would need to increase again if a weaker franc loosened monetary conditions.

SNB Chairman Roth again repeated that the inflation outlook had deteriorated since March and that the economy remained strong

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After gains to highs just above the 0.85 level, the Australian dollar weakened sharply to lows near 0.8360 before a recovery back to 0.8500 on Friday in choppy trading.

There was little in the way of domestic economic data over the week with global market trends remaining the dominant influence.

The Australian dollar was unsettled by weaker commodity prices in the middle of the week. Metals prices were able to recover in tandem with an improvement in stock prices which helped underpin the currency.

Underlying confidence should remain in the short-term, but the global credit tightening will tend to erode Australian dollar support which will make it difficult to extend gains.

Canadian dollar

The Canadian dollar found support close to 1.0750 against the dollar and strengthened back to highs beyond the 1.06 level as the break of US dollar support levels encouraged further Canadian buying.

There was a drop in wholesale prices, but markets were still looking for a July interest rate increase from the Reserve Bank.

The Canadian dollar was supported by merger-related inflows during the week.

Overall, the Canadian dollar should retain a firm short-term tone on expectations of a July rate increase, but it will be difficult to secure strong gains from current levels.

Indian rupee

There was evidence of exporter dollar selling close to the 41.0 level which limited the potential for US currency gains and a recovery in stock prices strengthened the rupee towards 40.75 on Friday.

High oil prices exerted some downward pressure on the currency over the week and curbed currency gains with markets also cautious over potential central bank intervention.

The rupee fluctuated in line with movements in carry trades and regional stock markets with calmer conditions providing rupee support late in the week.

The currency gained support from capital inflows associated with the Sterlite IPO offering.

The rupee should remain firm in the short-term, but capital inflows are liable to be more cautions with the potential for at least a small correction weaker and the possibility of a larger correction.

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The Hong Kong dollar was trapped with relatively narrow ranges during the week with the currency generally close to the 7.8150 level and it weakened slightly to 7.8165 on Friday..

There was firm Hong Kong dollar demand associated with future IPO offerings.

Local inter-bank interest rates drifted higher before the month-end period which supported the Hong Kong currency.

Any significant currency gains still attracted arbitrage activity and Hong Kong dollar selling.

Narrow ranges should prevail in the short-term with the potential for Hong Kong dollar selling close to the 7.81 level. Arbitrage selling will fade on any approach to the 7.82 level.

Chinese yuan

The Chinese yuan has edged stronger over the past week, although movement has been limited with the reference rate only strengthening slightly. The mid-point pushed to a high of 7.6135 on Wednesday before slight depreciation.

The Chinese authorities have attempted to clamp down on speculative capital inflows, but the short-term currency impact should be limited given the size of commercial inflows.

The plans to issue a yuan-denominated bond in Hong Kong led to speculation of increased Chinese currency demand.

Given the weight of capital inflows, the yuan should continue to appreciate gradually over the next few weeks with officials retaining tight control.