Weekly Forex Currency Review 29-07-2011

The US debt-ceiling situation will be watched very closely in the short-term and any outcome which resulted in default would cause very serious market stresses. Ironically, the US dollar could actually gain support as underlying risk appetite would deteriorate sharply, and there would be increased fears surrounding the European banking sector. Some form of compromise deal remains the more likely outcome which would maintain speculation over a US credit-rating downgrade. Volatility levels are liable to remain elevated, especially with doubts over the global economy.

Key events for the forthcoming week

Dollar:

Negotiations surrounding the US debt ceiling will continue to be watched very closely as congressional leaders battle to meet the August 2nd deadline, although the Treasury would be able avoid default for a further period. Failure to reach agreement would severely damage dollar sentiment, although it could gain defensive support if global risk aversion deteriorated sharply. There will still be underlying fears over a credit-rating downgrade even if default is avoided. The economy is likely to remain subdued in the short-term and the Federal Reserve will keep an accommodative monetary policy which will limit US yield support. Heavy selling should be avoided given the dollar remains substantially under-valued from a longer-term perspective.

The dollar secured net gains against the Euro with a move to near 1.4250 and did manage to stabilise on a trade-weighted index, but it was still searching for sustained buying support as US economic and debt-rating fears increased.
 
The US economic data was stronger than expected with jobless claims falling to 398,000 in the latest week from 422,000 previously while there was a 2.4% increase in pending home sales. The US Beige Book reported that activity had slowed in some districts during the past few weeks and there was also a weaker than expected durable goods report with a 2.1% decline for June.

The data impact was over-shadowed by congressional inability to secure any agreement over the budget and debt ceiling.  Markets continued to fret over the possibility of a debt default, although Treasury sources indicated that there would be some room for manoeuvre after the August 2nd deadline. It is also the case that markets, at this stage, are more worried over the threat of sovereign-rating downgrade by at least one of the major agencies. There is certainly a high risk that underlying damage caused by the default impasse will trigger a ratings downgrade.

After tortuous hours of negotiations between Republican members, the scheduled House of Representatives vote on its debt-ceiling bill was postponed and then finally cancelled as the leadership did not have the votes to pass the legislation. Market anxiety inevitably increased sharply following the vote cancellation as there would be no real possibility of any agreement being reached ahead of the weekend, especially as the Senate has already pledged to reject the House bill.

There will be increased fears that the US could default and contingency planning will be watched very closely during Friday. The net impact was to weaken the dollar, although clear direction was lacking as players looked for defensive plays.

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The Euro has struggled to maintain the support seen following the Greece rescue package with markets still uneasy over the contagion risk. Given that legislation will be required to secure additional funding for the EFSF, markets will be concerned that there will still be a lack of effective response if other peripheral economies come under attack and there will be further concerns surrounding Italy and Spain. The ECB will also come under heavy criticism if there is evidence of further economic deterioration. In this context, the Euro will find it difficult to take advantage of US vulnerability.  

Last week’s EU summit agreement to provide an additional EUR109bn support package to Greece did initially support the Euro, but it was unable to sustain the gains as underlying doubts persisted.

German Finance Minister Schauble warned that there was no blank cheque related to EFSF funds which ensured further political doubts over the Greek rescue deal, although he also stated that there should be no un-controlled exits from the Euro area.

There were renewed tensions surrounding Euro-zone peripheral bond markets with Italian and Spanish yields rising sharply. Weak demand pushed Italian yields to an 11-year high which increased the fear of contagion and had a negative impact on the Euro. There was also further evidence of stress within the banking sector.

Moody’s put Spain’s credit rating on review for a possible downgrade and downgraded regional ratings which reinforced the potential contagion risk and there were further concerns over the Euro-zone banking sector.

Yen:   

The yen will continue to gain some defensive support from a lack of confidence in the US and Euro-zone economies and any US default could trigger big yen gains. Safe-haven demand for the currency will also tend to increase if fears surrounding the global economy intensify.  There will be some speculation over a reduction in domestic leveraged currency positions which will tend to support the yen.  There will be further concerns over competitiveness and pressure for intervention will intensify even if there is no US backing. Overall, the dollar will find it difficult to secure more than limited gains.  

The dollar was unable to make any impression on the yen during the week and was subjected to renewed selling pressure in Asian trading on Friday as the yen gained from weak risk appetite. There was also further speculation over a decline in speculative short yen positioning as the lower Japanese margin requirements come into effect next week. The dollar dipped to test fresh 4-month lows below 77.50 against the yen on Friday as US deadlock persisted.

There was an improvement in Japan’s July’s PMI manufacturing index, but the industrial production and household spending figures were both below expectations which dampened expectations over the pace of Japan’s economic recovery.

There were further verbal warnings over the yen’s level from Finance Ministry officials, but there was no evidence of intervention with speculation that there would be no action until the US debt situation had been resolved.

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Confidence in the economy will remain weak with further concerns over the growth outlook. Expectations of a loose monetary policy will continue to undermine Sterling yield support and underlying confidence in the government’s economic policies is also liable to falter if business confidence deteriorates further. There will be some further short-term protection and possible safe-haven demand from fears over the US and Euro-zone outlook, but Sterling will find it difficult to gain more than limited support given the weak underlying fundamentals and fears over a renewed downturn.

Sterling proved broadly resilient during the week with little net change against the dollar while it did advance against the Euro with Sterling being seen ironically as a potential safe-haven despite fears over the economy.

There was relief over a 0.2% quarterly increase which was in line with market expectations, especially given fears that there could have been a contraction. There were distortions caused by the Royal wedding and bank holidays with the ONS estimating that there could have been an underlying 0.7% increase for the quarter.

The latest consumer confidence index recorded a further decline to -30 for July from -26 previously which was a fresh two-year low and maintained fears over the economic outlook, especially with downbeat CBI surveys on manufacturing and consumer spending as sales expectations declined to a 12-month low.  The Nationwide did report a 0.2% monthly increase in house prices for July.

Bank of England MPC members Miles and Weale both warned that the economy could retreat back into recession, although this was not his expected outcome. He also stated that inflation was a real concern, illustrating the serious difficulties faced by the Bank of England in setting policy.

International considerations remained extremely important and, despite unease over the economic outlook, Sterling did appear to be receiving some defensive support as risk appetite deteriorated. There was a decline in UK benchmark bond yields as US confidence deteriorated.

Swiss franc:

The franc will continue to be influenced very strongly by the Euro-zone stresses and degrees of risk appetite within global markets, especially with the US debt issue still unresolved.  Underlying confidence is liable to remain very weak which will maintain the potential for capital flows into the Swiss currency. Domestic policies will be watched closely as there will be additional pressure on the National Bank to intervene or impose capital controls if there are any fresh gains for the Swiss currency, especially as the latest business-confidence surveys have shown a significant deterioration.  

International influences continued to dominate the franc during the week with the Euro-zone and US both plagued by structural vulnerability and close to record lows against the Swiss currency.

The dollar did find some support below 0.80 against the franc with some further reports that option-related positions below this level were being defended. The US currency was still unable to make any headway as the franc maintained a strong tone on the crosses. The Euro retreated to lows below 1.1450 before finding some temporary respite.

Domestically, the KOF index weakened to 2.04 for July from 2.23 previously and, although still robust in historic terms, there will be unease over the recent deterioration in confidence surveys.  

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The Australian dollar maintained a firm tone over the first part of the week and then advanced strongly to fresh 30-year peaks above 1.1050 against the US currency.

The latest inflation data was stronger than expected with a 0.9% headline increase for the second quarter while there was also a core 0.9% increase. The data revived speculation that the Reserve Bank could increase interest rates further which put upward pressure on the Australian currency

The currency was unable to sustain the gains as there was greater caution surrounding risk as US law-makers failed to secure a deal to raise the debt ceiling. There were also fresh concerns surrounding the Chinese economic outlook.

The international risk profile is liable to deteriorate further given fears over the Chinese economic outlook with the Australian dollar struggling to sustain gains.

Canadian dollar:

The Canadian dollar pushed to three-year highs against the US dollar during the week, but was unable to break through the 0.94 level which helped trigger a partial retreat.

Underlying risk conditions also deteriorated which had a negative impact on the currency, especially as there were increased fears over the global growth outlook. There were no major economic releases during the week and markets were slightly more cautious in predicting higher interest rates.

The fundamentals should remain broadly favourable, but the Canadian dollar will find it difficult to advance given the international risk considerations.

Indian rupee:

The rupee advanced strongly over the first half of the week and pushed to a high beyond 43.90 against the US currency which was a 3-year high for the currency.

The Reserve Bank of India increased interest rates by a further 0.5% following the latest council meeting, the 11th increase since the first quarter of 2010. There were hopes for capital inflows  and the local stock market was also resilient.

The currency should be able to remain resilient given hopes for equity-related and investment capital inflows, but gains are likely to be limited at best.

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The Hong Kong dollar was confined to relatively narrow ranges with a weaker tone for the week as a whole as it retreated to near 7.7950 against the US dollar.

There was a generally cautious tone towards risk appetite with fears surrounding the US debt situation and underlying unease over the Euro-zone outlook. The general sense of disquiet was compounded by uncertainty over the Chinese economic outlook.

Although the Hong Kong dollar will gain support when risk appetite improves, uncertainty surrounding regional economic trends is liable to be dominate.

Chinese yuan:

The Chinese yuan secured net gains during the week with the Chinese currency pushing to near 6.44 against the US currency. There was only a limited retreat when the Euro dipped sharply which suggested that the bank was looking for a firm yuan.

Official reaction to the US debt impasse was measured, although there appeared to be clear frustration over the situation and some further expectations of medium-term diversification away from the US currency.

There was further uncertainty surrounding the Chinese economy during the week with further speculation over the bad-debt burden surrounding local government and debate surrounding the extent of any slowdown in the economy.

Although gradual appreciation may suit the central bank, this pattern could be at risk given a growing threat of instability and fears surrounding the Chinese economy.