Weekly Forex Currency Review 02-09-2011

The financial sector will be an important focus in the short-term with further speculation that liquidity and solvency will deteriorate further which could cause severe stresses within Europe.  If doubts over the Euro’s future also intensify again, there could be substantial defensive capital flows into the US dollar with volatility set to increase again.  

Key events for the forthcoming week

Dollar:

There will be expectations of persistently weak growth in the short-term with fears that the economy is close to recession. The Federal Reserve will look at options to support the economy and, even if further quantitative is resisted in the near term, yield support will continue to be very weak.  There will be further fears surrounding the global economy and there will also be a lack of confidence in the European banking sector. In this environment, there is still the potential for defensive dollar support, especially as confidence in emerging markets is also liable to fade, but the dollar will find it hard to gain strong support.

The dollar secured net gains as European currencies faltered again and there was asset allocation in favour of the currency as the Euro tested support below 1.4250.

The US consumer confidence data was even weaker than expected with a decline to 44.5 for August from a revised 59.2 the previous month which was the lowest reading since April 2009 and reinforced fears over the economic outlook, especially with increased pessimism over the employment outlook.

The latest FOMC minutes suggested that there was lively discussion at the last Fed meeting with a clear divergence in view. The dissenters were uncomfortable with a commitment to keeping low interest rates until 2013 and Kocherlakota emphasised his inflation concerns in a speech on Tuesday. In contrast, some members of the FOMC wanted further policy action at this time. The minutes confirmed the decision to hold a two-day meeting in September as indicated by Bernanke at the end of last week.

The latest ADP employment report registered private-sector job gains of 91,000 in August from a revised 114,000 previously. Given that government jobs have consistently declined over the past few months, there were continuing expectations of poor payroll growth in the Friday employment report.

There was some relief surrounding the latest US ISM manufacturing survey as it fell to 50.6 for August from 50.9 previously. Although this was the lowest figure since 2009, there had been expectations that the figure would drop significantly below the 50 threshold. There was some disappointment over the employment component which was the weakest since November 2009.

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There will be expectations of a sustained downturn in the Euro-zone economy. This will be particularly dangerous for the Euro-zone as it would also increase pressures within the peripheral economies and put additional strain on the debt profile. There is likely to be a shift in ECB policies as there is little credibility in suggesting that interest rates are likely to increase again. The ECB will also be very important in supporting peripheral bond markets, but this is not sustainable in the long term. Political negotiations surrounding an expanded EFSF will also be watched closely. The Euro will be vulnerable to heavy selling if fears surrounding the banking sector increase.

The Euro was subjected to renewed selling pressure as confidence in the Euro-zone financial sector remained extremely fragile.
 
ECB President Trichet stated that underlying inflation risks were being re-assessed and that a new report would be available for the September ECB policy meeting. Trichet stated that inflation would remain above 2.0% in the short-term, but there was further speculation that there would be a downgrading of internal inflation forecasts which would also nullify any further talk of higher interest rates.

The latest PMI data was weaker than expected with the revised manufacturing index dipping to the lowest level since June 2009 with a reading of 49.0 from the flash 49.7 estimate which suggests that conditions deteriorated sharply late in the survey period.

The German government approved new powers for the EFSF, but there will be a tough battle to approve the legislation in the Bundestag given that several governing-party members are opposed to the changes. There were also increased fears that the complex rules surrounding the fund would prevent it responding effectively to a crisis.

There were further concerns surrounding the European banking sector with reports that many banks were effectively shut-out of international markets or were able to access funds for very short-term periods only. There was further buying of European peripheral bonds by the ECB, but the impact was less than that seen in previous days and it struggled to overcome the negative impact of weak demand in the latest Spanish auction. There was further speculation over a more dovish ECB policy next week as bank member Nowotny stated that there would be lower inflation in 2012.

There was another warning over the ECB policies from the German Bundesbank as underlying tensions remained high with further reports from the IMF-led mission to Greece that budget targets would be missed.

Yen:   

There will be expectations that the new government will announce additional measures to curb yen appreciation which will deter speculative buying. There will still be a high degree of caution surrounding the global economy which will limit any selling pressure on the yen, especially with growth conditions still deteriorating. There will continue to be some support for the yen as a safe haven, especially with a lack of attractive alternatives. The dollar will also find it hard to make strong headway given the lack of yield support.    

The dollar challenged levels above 77 during the week, but was unable to make strong headway as resistance remained very tough to break down. Risk conditions remained import for the Japanese currency as underlying confidence remained fragile.
 
The latest Japanese economic data was slightly weaker than expected with the PMI manufacturing index falling to 51.9 from 52.1 while the industrial production increase was also lower than expected at 0.6% for the month which will tend to increase fears that economic recovery is stalling.

The government announced that it would announce additional steps to weaken the Japanese currency over the next few weeks, but the yen was still resilient with increased demand from exporters underpinning the currency. The Bank of Japan confirmed that its intervention during August was the highest amount since 2004.

There had been speculation that Okada would be appointed as Finance Minister, but Noda appointed Azumi who has little experience in financial matters. This may dampen immediate speculation over fresh intervention to weaken the yen.

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Confidence in the economic outlook will remain extremely fragile in the short-term. The Bank of England will keep interest rates at extremely low levels and, although it is not likely to make a near-term move to boost quantitative easing, there is the possibility that this will be a medium-term option which will curb Sterling buying support. Sterling is also not well placed to secure substantial defensive inflows given underlying economic weakness and fragile banking sector.  Weakness elsewhere may be effective in curbing heavy selling pressure.

Sterling retreated over the week with significant loses against the dollar as a dip in any safe-haven support for the UK currency coincided with fresh US demand.  The Euro failed to hold its best levels as month-end demand faded.

The UK lending data remained subdued with a net GBP0.7bn increase in personal lending for July and money supply growth also remained lacklustre, although the mortgage approvals data was slightly stronger than expected. The latest CBI survey for services-sector activity recorded a sharp deterioration in confidence and orders for the third quarter and this will maintain fears over the economic outlook

The PMI manufacturing index weakened to 49.0 for August from 49.4 previously and this was the lowest reading since June 2009, although there was some relief that the release was not even worse. There will be continuing expectations of a weak economy, especially if there is any deterioration in the services-sector data.

The Bank of England will keep interest rates at extremely low levels and markets will watch any hints over quantitative easing very closely in the near term.

Swiss franc:

The Swiss authorities will remain extremely concerned over the impact of a very strong franc, especially with business confidence deteriorating sharply. The National Bank will keep market interest rates in negative territory, but efforts to weaken the currency will certainly be undermined if there is evidence of serious stresses between the central bank and government.  There will still be the potential for capital inflows from the Euro-zone given fears over the Euro-zone outlook and volatility is likely to remain high in the near term.  

After initial franc weakness at the start of the week, the Euro was subjected to renewed selling pressure against the franc from mid-week and  retreated to test support below 1.13. In this environment, the dollar was unable to sustain gains to 0.82 with lows near 0.7925 as the 0.80 support area was broken.

The government announced no new measures to weaken the franc and stated that the country would have to live with a strong currency. There were also suggestions that there was a disagreement with the National Bank over the effectiveness of measures which triggered strong flows back into the Swiss currency.

Domestically, the PMI August reading fell to 51.7 from 53.5 while the annual growth in retail sales slowed to 1.9% from 7.4% previously.  Evidence of a sharp slowdown will maintain pressure on the National Bank to curb any further franc appreciation.

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The Australian dollar found support below 1.0450 against the US dollar and rallied steadily to test highs above 1.07 during the week.  Although risk appetite remained fragile, there was a rebound in Asian equity markets which helped curb further selling pressure on the Australian currency.

The domestic retail sales data was stronger than expected with a 0.5% increase for the month which provided some degree of support for the currency after a series of weak releases and capital spending also increased. There was reduced speculation that the Reserve Bank would be in a position to lower interest rates, although there were still housing concerns as home sales fell sharply for the second successive month.

Although the Australian dollar has regained ground, the fragile international risk profile and increased concerns over the domestic economy will limit gains.

Canadian dollar:

The Canadian dollar found support weaker than the 0.99 level against the US dollar and advanced to highs near 0.9750, although moves in general lacked conviction. Some steadying in risk conditions provided support for the Canadian dollar.

There was a rebound in GDP growth for June following a drop the previous month, although the overall market impact was limited as international considerations tended to dominate.

The Canadian dollar is unlikely to advance significantly, especially as the underlying international risk profile is still extremely fragile.

Indian rupee:

The rupee maintained a weaker tone during the week and again tested support beyond the 46 level with monthly losses of over 4% as risk appetite deteriorated. There was also month-end demand for dollars from oil importers, although this pressure eased late in the week.

Underlying risk appetite remained fragile, illustrated by the fact that there were net outflows of foreign funds from the stock market of US$2.3bn which was the heaviest outflow since the fourth quarter of 2008.

The rupee will continue to be hampered by caution over risk and unease over a slowdown in the economy. Heavy losses from current levels should be avoided.

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The Hong Kong dollar was generally confined to narrow ranges during the week and found support in the 7.80 region against the US currency. There was solid corporate demand for the US currency which underpinned the unit during the week.

From a medium-term perspective, there were further stresses over potential outflows from  Hong Kong deposits, but also speculation that there would be a medium-term move to revalue the currency and align it closer to the yuan.

There will be further speculation that the Hong Kong dollar peg will need to be modified in the medium term which should curb any near-term selling pressure.

Chinese yuan:

The Chinese yuan maintained a generally strong tone over the week and briefly tested levels near 6.375 against the US dollar, but it was unable to sustain the gains, especially as there was wider Euro selling pressure over the second half of the week.

There was relief that the official PMI index held above the 50 level and there was further speculation surrounding monetary policy with some reports that reserve requirements could be lowered for smaller banks in order to ease property-sector stresses as fears over bad debts increase.

The PBOC is likely to maintain its policy of gradual yuan appreciation in the short-term as it balances inflation and growth uncertainties.