Weekly Forex Currency Review 03-10-2008

Overall strategy:

Conditions within the global economy and financial sectors will remain of critical importance in the short-term. Confidence in both the US and Europe is liable to deteriorate which may limit scope for currency moves, although volatility is set to remain at very high levels.  Until there is an significant improvement in liquidity conditions and an easing of fear, there will be further underlying defensive mentality with firm yen demand.

Key events for the forthcoming week

Dollar:

There will be increased fears that financial-sector turbulence and tightening credit conditions will undermine confidence and trigger a renewed downturn in the economy, especially as the most recent economic indicators have deteriorated sharply. There will be further expectations that the Fed will move to cut interest rates again this quarter. The dollar will continue to secure defensive support from fears over the global economy with a particular focus on Europe. There will also be technical support if there is no easing in global credit markets. Increased fears over the economy will make it difficult for the currency to extend gains. 

The dollar strengthened sharply over the week with gains to a 12-month high on a trade-weighted index while the US currency also rose to a 2008 high against the Euro.

Developments surrounding the US financial-sector rescue package remained an extremely important focus over the week and contributed to very high volatility.

The House of Representatives rejected the bailout package on Monday due to fears that it would be unpopular and this caused major stresses with Wall Street weakening sharply as the Dow Jones index recorded the sharpest ever one-day points decline.

The US data releases had a weak tone and suggested that demand may have suddenly weakened sharply. The ISM index for the manufacturing sector fell sharply to 43.5 in September from 49.9 the previous month as all the major components dipped sharply. Historically, a decline to below the 45 level has always signalled a recession.

In addition, there was a 4.0% decline in factory orders in August and car sales weakened sharply while jobless claims edged higher to 497,000 from 496,000 previously, also at a seven-year high, which suggests recession.

In contrast, the monthly ADP release reported that the decline in private-sector employment had been held to 8,000 for September. Consumer confidence also increased, although the survey did not capture the most recent financial turbulence.

Later in the week the Senate passed an amended bailout package with the House due to vote on Friday, but US asset prices remained on the defensive as Wall Street came under renewed pressure on wider fears over the economic outlook

There were still severe structural difficulties in the money markets with a further dollar shortage as institutions hoarded cash. Interest rates remained at elevated levels despite further massive liquidity injections by the central bank and the technical factors helped underpin the US currency as institutions were forced to buy. Tensions eased marginally in Asian trading on Friday.

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There will be further expectations that the Euro-zone economy will weaken, especially with confidence continuing to weaken. There will also be increased fears over the banking sector given recent government intervention. There will also be increased pressure for the ECB to loosen policy and the press conference this week suggest that the bank will move towards cutting rates over the next few weeks.  Nevertheless, unless there are major dislocations within the banking sector, the Euro should be able to resist heavy selling from current levels.               
       
The Euro weakened sharply over the week due to increased fears over the economy and renewed stresses within the banking sector, coupled with increased confidence that the ECB would move towards a policy relaxation.

The Euro-zone data remained generally weak with a further decline in business confidence for September while the revised September PMI indices were revised slightly lower. There were some areas of strength with German unemployment continuing to decline, but this was seen as a lagging indicator.

The flash Euro-zone September consumer prices estimate recorded a decline in the year-on-year rate to 3.6% from 3.8% and producer-price inflation also eased.

The banking sector was an important focus over the week. The Belgian authorities were forced to provide a support package to Fortis while the French government also stepped in to provide additional capital for Dexia. The Irish government announced that all banking deposits would be protected to help support the sector

The ECB left interest rates on hold at 4.25% at the latest council meeting. In the press conference following the decision, Chairman Trichet stated that the inflation risks had diminished while the market turbulence had increased. The comments were taken by markets to confirm that the bank had moved to an easier bias and would look to cut interest rates at or before the November meeting.

Yen:  

The evidence continues to suggest a serious weakening in the economy with recession fears an important domestic influence. The yen moves will still tend to be dominated by the degrees of global risk aversion. The currency will continue to gain important defensive support, especially as the Japanese banking sector appears substantially less vulnerable than banks in the US and Europe. There will be important yen selling at times if risk appetite improves, but the net risks suggest that substantial yen losses are unlikely at this stage.
                   
The Japanese currency weakened at times, but secured net gains over the week and was particularly strong on the principal crosses with a two-year high against the Euro while it consolidated near 105 against the dollar.

The yen moves were still dominated to large extent by degrees of risk aversion and underlying tensions provided important yen support. The currency gained sharply as Wall Street was subjected to heavy selling pressure and retained a firm tone.

The perception that Japanese banks were far less vulnerable to serious stresses helped support the yen with a greater reluctance to push funds overseas.

The quarterly Tankan business confidence survey for the manufacturing sector weakened to -3 from +5 previously, reinforcing expectations of a serious slide in the economy. There was also a sharp drop in industrial production for the latest month.

Unemployment rose to 4.2% from 4.0%, although there were strong gains for housing starts which provided some relief. There were reports that the government would consider a second fiscal package to help support the economy.

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The economy is set to weaken further in the short-term with severe stresses in the housing sector while banking fears will further erode confidence. The Bank of England will still be concerned over inflation, but there will be very strong pressure for the MPC to move quickly towards cutting interest rates. The UK currency will secure some important protection from fears over the Euro-zone and the deteriorating US outlook. Nevertheless, sentiment will remain very fragile and the short-term outlook is likely to be neutral at best.

The UK currency advanced against the Euro with a push to a 7-wek high near 0.7810, but reversed the recent recovery against the dollar with a move to 1.76 in volatile conditions. For the quarter, losses against the dollar were the steepest for 16 years.

The financial sector remained a key focus with the Bradford & Bingley taken into public ownership as it faced collapse and there were wider fears over the sector

The economic data maintained a very weak tone which reinforced fears over the economy. The PMI index for the manufacturing sector weakened to 41.0 in September from 45.3 the previous month and this was the weakest reading for 16 years while the services-sector report also fell sharply to 46.0 for the month.The mortgage approvals data remained extremely weak with a sharp reduction in mortgage financing while net consumer lending also weakened very sharply over the month. The data reinforced fears over the hosing sector and the economy. GDP for the second quarter was confirmed at 0.0% while business investment remained weak.

The Bank of England quarterly survey recorded a further tightening of credit conditions with the situation likely to tighten further and there was further pressure for lower interest rates, especially as market interest rates remained at elevated levels.

Swiss franc:

The Swiss economy will continue to weaken in the short-term, although the evidence does not suggest that pace of deterioration is any worse than in the Euro-zone.  The domestic financial sector will also be watched very closely and there will be fears that the financial sector will deteriorate further. Any evidence of severe stresses in the local banks would put substantial downward pressure on the Swiss currency. If this is avoided, then the franc will still secure important defensive support as risk aversion remains very high.    

The Swiss franc retained a firm tone against the Euro while it dipped to 12-month lows against the dollar with a US currency peak above 1.14. The franc was able to gain some traction against the Euro with highs near 1.56.

The PMI index weakened to 47.9 in September from 52.5 the previous month and this was the first reading below the 50.0 level for the first time in over three years.

The National Bank stated that 2009 growth would be materially weaker than 2008 which maintained expectations of a sharp slowdown.

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The Australian dollar was unable to sustain rallies and weakened to lows around 0.77 against the US dollar late in the week. The currency was undermined by the general increase in risk aversion and a sharp decline in commodity prices as industrial metal prices weakened to the lowest level for 12 months on growth fears.

The domestic data was mixed with a small increase in retail sales while there was a decline in building approvals which undermined confidence in the building sector. The manufacturing and services PMI indices remained well below the 50.0 threshold.

The Australian dollar has scope for a limited recovery against the US currency, but rallies are liable to stall relatively quickly given the increasing growth fears.

Canadian dollar:

The Canadian dollar was unable to break the 1.03 level against the dollar and dipped sharply to lows beyond 1.08 late in the week as the US currency rallied strongly. 

The Canadian GDP data was stronger than expected with a 0.7% increase for August, although the data failed to have a sustained impact with fears that the economy was set to weaken. Markets were still expecting the Bank of Canada to sanction an interest rate cut at the October meeting.

The Canadian dollar should retain a firmer tone in the short-term, although it will be difficult to make much headway from current levels.

Indian rupee:

The rupee remained under heavy selling pressure over the first half of the week and dipped to 5-year lows beyond 47.20 against the US dollar. The rupee twice recovered from this level with support from central bank intervention and heavy dollar selling by foreign banks as local inter-bank rates increased.

The currency was constantly undermined by the underlying decline in risk appetite as investor confidence remained frail with sustained declines in regional markets.

The trade deficit widened to US$13.4bn from US$10.8bn the previous month which reinforced fears over the underlying economic trends even though oil prices fell.

Confidence in the economy and region will remain very fragile in the short-term. In this environment, the rupee is unlikely to secure a substantial recovery.

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The Hong Kong dollar was little changed for the weak as whole despite choppy trading conditions and it consolidated close to the 7.77 level against the US dollar. There were further notable strains in the local money markets and the HKMA announced a raft of measures to boost liquidity.

The currency was still unsettled by fears over the regional economy and the underlying credit risks with the regional stock markets remaining under pressure.

Overall, the Hong Kong dollar will struggle to secure further gains, especially as underlying confidence in the regional economy is liable to weaken.

Chinese yuan:

The Chinese markets were closed for the week due to national holidays and the yuan settled close to 6.8450 against the dollar

There will be further expectations that the Chinese authorities will maintain a greater emphasis on supporting the economy which will limit currency support.

Unease over the domestic and regional economic trends will continue to limit the scope for near-term yuan appreciation with the central bank likely to promote near-term stability given the domestic and international uncertainties.    

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