Weekly Forex Currency Review 01-04-2011

Overall strategy:  Monetary policy trends will continue to be watched very closely in the short-term with European and US developments in focus. There is a strong probability that the ECB will increase interest rates, but it is still doubtful whether such a policy move will provide durable Euro support given the structural vulnerability and gradual move towards a policy change by the Federal Reserve.

Key events for the forthcoming week

Market analysis

Dollar: 

The US economic data has maintained a generally solid tone, with notable strength in the manufacturing sector, although there was also a decline in consumer confidence as energy prices remained high. Federal Reserve policies will remain an important focus following the recent more hawkish tone and there will be speculation that the Fed will shift to a tighter bias and not extend the current quantitative easing programme. Any benefit to the dollar will be offset by expectations that interest rates will still be kept at very low levels. Longer-term confidence in the currency is also likely to remain generally very fragile.

The dollar gained some support from expectations of a shift in Fed policies, but will found it very difficult to make headway, especially against commodity currencies, and the Euro re-tested resistance above 1.42.

The US consumer confidence data was slightly weaker than expected with a decline to 63.4 for March from a revised 72.0 previously while the Case-Shiller house-price index registered a 3.1% decline in the year to February.

US jobless claims fell to 388,000 in the latest reporting week from a revised 394,000 previously while the Chicago PMI index edged lower to 70.6 from a revised 71.2. The data overall reinforced expectations of solid economic growth and confidence will remain firm if there is robust payroll data on Friday.

Following comments over the weekend, Regional Fed President Bullard stated that the bond-buying programme could be reduced by US$100bn to US$500bn given the stronger economy. Although not an FOMC voting member this year, Bullard worked closely with Chairman Bernanke last year and there will be speculation that his more hawkish tone is also a subtle indicator of a change in thinking within the FOMC. There were higher US Treasury yields which provided some dollar support.

There was further speculation that the Federal Reserve would not look to extend the quantitative easing programme beyond June and could even curtail the existing bond-buying programme early. Comments from Fed officials remained generally more hawkish later in the week with Regional President Kocherlakota stating that interest rates may need to rise before the end of 2011

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The Euro will continue to gain near-term support on interest rate grounds with a very high probability that interest rates will be increased at next week’s meeting and there will also be some speculation that the ECB will look for a series of rate increases.  The structural vulnerabilities will also be a constant focus and will certainly sap confidence at times with expectations that debt restructuring will eventually be required which would trigger additional stresses within the banking sector. There is still an important risk of sharp medium-term selling pressure on the Euro given these vulnerabilities.

The Euro was able to prove resilient in the face of structural fears with monetary-policy considerations dominant over the week.

The flash Euro-zone inflation rate rose to 2.6% for March from 2.4% previously as energy costs continued to spike higher. ECB officials maintained a tough tone on inflation and the data will reinforce inflation fears within the ECB which will also make the central bank even more determined to raise interest rates next week. There will also be additional speculation that the bank will plan a series of rate increases, although this will certainly be more contentious, not least as it will exacerbate political tensions surrounding weaker Euro-zone members.

Standard & Poor’s downgraded Portugal’s credit rating again and warned of further action over peripheral ratings over the next few weeks. Markets continued to expect an imminent move by Portugal to ask for EU support and underlying confidence remained extremely fragile, especially with fears that Spanish savings banks would require additional support.

Portugal revised up the 2010 budget deficit following a change in accounting methods and a general election will be held in early May. At current yields, Portugal remains effectively shut out of bond markets and there will be further expectations that a bailout package is inevitable. There were no further surprises from the Irish banking-sector stress tests, but the situation remains perilous and structural fears remained a very important market issue which will certainly unsettle the Euro at times.

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From a medium-term perspective, there will be a further erosion of confidence in the Japanese fundamentals as the debt burden continues to increase and the government is forced to maintain a highly-expansionary fiscal policy. The Bank of Japan will also maintain a very aggressive monetary policy to help support the economy. The yen will lose support when risk appetite improves, especially as the currency will be seen as a more attractive funding currency if there is increased speculation over a Fed tightening. There will still be some reservations over selling the yen aggressively with high volatility still an important feature.

The dollar found support above 81.50 against the yen early in the week and managed to break a series of resistance levels with a peak near 83.70 in Asia on Tuesday.

The yen remained vulnerable against the dollar on yield grounds, especially with further speculation that the Fed will shift towards a tighter monetary policy. There was also further interest in carry trades funded through the yen as markets looked to take a positive attitude towards risk.

The Japanese Tankan report was broadly in line with market expectations with a rise to 6 in the first quarter from 5 previously. The impact was limited, especially as a high proportion of the responses were received before the March 11 earthquake. There was some disappointment that capital spending plans were scaled back and underlying confidence in the Japanese fundamentals remains weak. 

Capital repatriation flows also slowed which lessened support for the yen. Industrial production rose 0.4% for February, but the impact was minimal given that production will dip sharply in the near term. There were suggestions that an initial extra budget could be in the region of JP2trn and the fiscal position remains perilous.

Sterling:

Growth and inflation trends will continue to be watched very closely in the near term. There will be strong pressure on the Bank of England to raise interest rates on inflation grounds, especially as the headline rate could move above 5.0%.  There will be a lack of confidence in the growth outlook, especially with consumer spending already vulnerable, and real interest rates will remain highly-negative for Sterling which will have a negative impact. There is also the risk of fresh doubts surrounding the banking sector which could have a serious negative impact on the UK currency.   

Sterling remained under pressure early in the week and dipped to two-month lows around 1.5935 against the US dollar while the trade-weighted index declined to a 2011 low. The Irish and European banking sector will be watched closely as renewed stresses would also tend to unsettle the UK currency.

Fourth-quarter GDP data was revised to -0.5% from -0.6% previously while there was also some improvement in bank lending and mortgage approvals. The current account deficit for the fourth quarter widened to GBP10.5bn from GBP8.7bn previously as the goods deficit widened to an all-time high. The data overall continued to suggest a very fragile economy, but also indicated the possibility that credit conditions were easier.

Business confidence dipped and there were increased fears that the tight government fiscal policy would have a greater than expected impact in weakening the economy with spending hit by falling real incomes. There were also expectations that weak growth would deter the Bank of England from more than a marginal monetary tightening which would leave interest rates highly negative in real terms.

There was a stronger than expected CBI retail sales report for March. In comments on Tuesday, MPC member Weale maintained his call for an early increase in rates to stem inflation which provided some Sterling support.

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The franc will continue to be strongly influenced by trends in risk appetite and there will certainly be support at times when Euro-zone fears increase. The franc has found it more difficult to gain support over the past week and the currency will be seen as an attractive funding currency risk conditions deteriorate, especially given the underlying Euro-zone area fears. There will also be optimism that the economy can deal with the impact of currency strength following the recent favourable growth indicators. High volatility is likely to remain an important factor on major shifts in international sentiment with the franc vulnerable on valuation grounds.

There was further international interest in carry trades which had an important negative impact on the franc with the Swiss currency seen as an attractive funding currency if there is a sustained improvement in risk appetite. The Euro attempted to sustain a move above 1.30 while the dollar tested resistance near 0.9250.

There were still be fears over the Euro-zone structural vulnerabilities which tempered franc selling to some extent and volatility levels are liable to remain high.

The Swiss KOF business confidence index was slightly stronger than expected at 2.24 for March from a revised 2.19 previously and this remains a very high figure historically which will boost confidence in the economy. In its latest report, the International Monetary Fund (IMF) stated that the Swiss National Bank should start raising interest rates in order to contain inflationary pressure.

Australian dollar:

The Australian dollar maintained a strong tone during the week as it pushed to fresh 29-year highs against the US dollar with a peak above 1.0350.

Risk appetite was generally firm during the week which encouraged a flow of funds into the Australian currency, especially as there was a firm tone in commodity prices.

There was mixed domestic economic data with a solid reading for retail sales and a rise in credit. In contrast, there was a further decline in building approvals and the PMI manufacturing sector dipped back to below the 50 level for the latest reading.  

Even though the currency will stay strong initially, reservations over domestic and global conditions will leave the Australian dollar vulnerable to a sharp correction.

Canadian dollar:

The Canadian dollar was able to maintain a strong tone during the week as the US currency consistently failed to gain any traction and the Canadian currency was able to test levels beyond 0.97. There was currency support from high oil prices and generally robust risk appetite.

The GDP data recorded a 0.5% increase for January which was broadly in line with expectations and did not have a major impact. The government was defeated in a no-confidence motion and there will be a general election in early May, but there was confidence that the policies would not change significantly which lessened the impact.

The Canadian dollar will continue to draw support from the high level of commodity prices. It will still be difficult for the currency to secure further significant gains.

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The rupee maintained a strong tone during the week and pushed to the highest levels since the middle of November with a move to the 44.60 area against the US dollar.

The Indian currency was again underpinned by a generally weak dollar and there was optimism over the economy as risk appetite improved. There was still dollar demand from importers and the oil sector which curbed rupee gains.

Markets will maintain an optimistic tone towards the rupee, but the domestic and international risk profile will make it difficult for the currency to advance strongly.

Hong Kong dollar:

The Hong Kong dollar found support just weaker than the 7.80 level against the US dollar early in the week and strengthened sharply to highs just beyond 7.7850.

The local currency gained support from a generally robust tone in risk appetite and there was also important support from market rumours that the HKMA had decided to abandon the currency peg against the US currency. The currency stabilised after these reports were denied.

The Hong Kong dollar will gain further support from speculation that there will eventually be a move to break the currency peg with the dollar.

Chinese yuan:

The yuan has maintained a strong tone during the past week and pushed to a fresh post-float high close to 6.552 against the US currency. There was a significant move by the regulators as they curbed speculative activity in the forwards market. The move to dampen banks’ ability to speculate on a stronger yuan increased market expectations that the central bank was looking for the spot rate to appreciate.

There was some caution over pushing the currency higher as economic doubts persisted with the latest PMI manufacturing data weaker than expected.

The evidence continues to suggest that the central bank will look for gradual yuan appreciation to help restore balance in the domestic economy and curb inflation.

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