Weekly Forex Currency Review 04-02-2011

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Inflation pressures will remain an important global focus in the short-term. Monetary policies will, therefore, also be a key policy area as central banks look to contain inflationary pressures. G7 countries will still find it difficult to tighten monetary policy substantially given structural vulnerabilities, but there will be speculation that Asian central banks will take further action to curb inflation.           

 Key events for the forthcoming week

 Market analysis

 Dollar: 

The general run of US data has remained favourable and there will be confidence surrounding robust growth for 2011.  The Federal Reserve is still concentrating on the employment outlook and further resistance to any policy tightening will limit any yield-related support for the US currency. There will also be further unease over the budget outlook, particularly as the AAA credit rating will remain under threat in the medium term.  The international developments will remain extremely important, especially. Any disruption to emerging-market capital flows could trigger sharp dollar gains and it will also secure important support at times from  the Euro-zone structural vulnerabilities.

The dollar remained on the defensive over the first half of the week and retreated to a 12-week low on a trade-weighted basis, but there was a recovery against European currencies as the Euro lost ground.

The US PMI manufacturing index rose to 60.8 for January from 58.5 previously and this was the highest reading for 7 years with the prices component also very strong. 

The headline ADP employment report recorded an increase in private-sector jobs of 187,000 for January which was again above market expectations. The impact was tempered to some extent by a downward revision to December’s data and there was an element of caution given that the official data did not match optimism triggered by the ADP report last month.

The US economic data was significantly stronger than expected with initial jobless claims declining to 415,000 in the latest week from a revised 457,000 previously while the ISM services-sector index also rallied to 59.4 from 57.1. The data will reinforce optimism over firmer growth conditions and there will be further optimism if there is a higher than expected employment figure released on Friday.

Benchmark Treasury yields rose to the highest level since June 2010. Fed Chairman Bernanke was more optimistic over economic conditions, but he also stated that the economy was still in a deep hole. Given the focus on employment, there will still be strong near-term resistance to higher short-term rates.

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Euro-zone political leaders have managed to keep market fears at bay and sentiment can remain firmer in the very short-term. There are still very important structural vulnerabilities and the Euro will be subjected to renewed selling pressure if fears intensify again, especially as there is still no clear escape route for weaker economies. The ECB is still concerned over the inflation outlook, but will find it very difficult to raise interest rates as this would further damage recession-hit economies.  The currency will also be sold heavily if the German courts rule that Euro-zone support measures were unconstitutional.

The Euro pushed to a two-month high above 1.3850 against the dollar during the week before being subjected to a heavy round of profit taking.

With the ECB also stopping its emergency buying of Euro-zone bonds, there were additional expectations that the bank would focus more on price stability and force the burden of rescuing weaker members on to national governments. There is, however, also the possibility that the bank is concerned over such bond buying being declared outside the Maastricht Treaty and any such decision from the German courts would cause serious stresses within the Euro area. Internal politics and discussions over the rescue mechanism will be watched closely at the EU Summit.

 Standard & Poor’s downgraded Ireland’s sovereign rating to A- from A which hampered the Euro and there were also expectations that an opposition victory in the February 25^th General Election would result in a re-negotiation of Irish bailout terms which would force bondholders to accept increased losses. There was disappointment surrounding the latest Spanish bond auction which also undermined the Euro

 Sources within the German government also indicated that they would oppose any proposals to allow the EFSF to buy existing Euro-zone debt. For now, markets may be prepared to give the governments more time to strengthen Euro-zone mechanisms.

The Euro-zone flash inflation estimate rose to a 27-month high of 2.4% for January from 2.2% previously as energy costs rose. As expected, the ECB left interest rates on hold at 1.00% ensuring that the press conference was the main focus.

President Trichet did point to short-term inflation risks, but he also stated that the medium-term risks were broadly balanced and that expectations were firmly anchored. The comments certainly dampened speculation over a near-term increase in interest rates which also put downward pressure on the Euro with Trichet pointedly moving away from an overtly hawkish tone. He also reiterated that the bank would wait for the new ECB staff projections in March and any substantial upgrading for the inflation forecasts would renew pressure for higher interest rates.

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Confidence in the Japanese economy will remain weak with investors still fretting over the longer-term debt fundamentals given the risk of further credit-rating downgrades. The  Bank of Japan will maintain a policy of extremely low interest rates with deflation still their paramount policy fear. There is also the possibility of intervention to stem yen gains if it approaches record highs against the dollar. Given the overall fundamentals, the yen outlook remains weak despite its current resilience against the US currency.

The yen weakened at times during the week, but was generally resilient during the week and regained ground on the crosses. Although the US economic releases were generally favourable, the dollar struggled to make headway with selling above 82.0.

The official Chinese PMI index did decline to 52.9 for January from 53.9, but there was a further increase in the prices component which may trigger fears over a further tightening of Chinese monetary policy.

The domestic data recorded a decline in average earnings for the first time in 8 months which will maintain fears over the outlook for consumer spending.  There were some reports of European bond-repatriation flows back to Japan which provided underlying support for the Japanese currency.

Japanese Finance Ministry comments will need to be watched very closely as there will be speculation over verbal intervention to weaken the Japanese currency if it advances towards the pivotal 80 level. 

 Sterling:

The most recent business confidence surveys have been stronger than expected which will ease immediate fears surrounding the UK economy. With inflationary pressures continuing to rise, there will also be strong pressure for the Bank of England to raise interest rates.  There will still be underlying caution, particularly as fiscal tightening will still undermine the economy’s growth potential.  There is also a high risk that the central bank will make policy errors which would undermine longer-term confidence in Sterling. Frequent shifts in sentiment and high volatility are likely to be the key features.

Sterling advanced firmly during the week and pushed to a three-month high above 1.6250 against the dollar before being subjected to profit taking.

The manufacturing PMI index rose to 60.8 for January from 58.5 the previous month and this was the highest reading since the survey started in 1992. There was also a very strong reading for the prices component which will maintain pressure for higher interest rates. The services-sector index rose to 54.5 for January from 49.7.

With inflation components also strong, there will be renewed pressure on the Bank of England to increase interest rates. This will tend to support Sterling, but there will still be doubts whether the economy will be robust enough to cope with higher borrowing costs. There will also be speculation that the central bank will lose control of inflation expectations which would undermine medium-term Sterling confidence. Former MPC member Barker warned over such a possibility in comments on Thursday.

Current MPC member Sentance maintained his preference for a small rise in interest rates to prevent the risk of a larger increase later. His colleague Bean was much more cautious over the need for higher borrowing costs, but did concede that higher commodity prices could force a change. Markets overall were more aggressive in pricing in rate increases which helped underpin Sterling.

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Defensive demand for the Swiss currency will diminish when confidence in the Euro-zone outlook improves, especially when there is a wider improvement in global risk appetite. The National Bank will certainly not oppose a weaker franc trend given fears over damage to the economy.  Sentiment could still reverse again rapidly if credit fears within the Euro-zone intensify and the franc will also gain important support if global risk appetite deteriorates.

The franc weakened against the Euro over the week as a whole, but trading conditions were still volatile. The dollar dipped to 2011 lows against franc before a recovery.

National Bank member Jordan stated that massive franc gains were a threat to growth and there will certainly be persistent alarm within the bank. For now, they will primarily see an improvement in Euro sentiment rather than intervention as the key to weakening the Swiss currency, but verbal opposition to franc gains is realistic.

There will be a reduction in defensive franc demand if there is a sustained improvement in sentiment surrounding the Euro-zone and there has been pressure for a closing of short speculative Euro positions.

Australian dollar:

The Australian dollar found support on dips to the 0.9850 area against the US currency and rallied firmly to a high near 1.02 late in the week as there was still strong-buying support for the currency.

The Reserve Bank held interest rates at 4.75% following the latest council meeting and the bank was generally optimistic over growth prospects which helped underpin the currency. The domestic data was mixed as a firm reading for building approvals was offset by further weakness in the PMI data series. The Australian currency drew support from higher commodity prices and resilient risk appetite.

There are likely to be reservations over the domestic and international outlook which will make it difficult for the Australian dollar to advance further.

Canadian dollar:

The Canadian dollar briefly dipped to beyond parity against the US currency during the week, but there was a quick recovery and it tested 2011 highs near 0.9870. The currency gained important support from elevated oil prices which helped cushion any potential negative impact from emerging-market fears.

The domestic influences were limited with a higher than expected GDP reading for November not having a major impact.

The general US dollar vulnerability will make it difficult for the US currency to secure any significant recovery against the Canadian currency.

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The rupee tested two-month lows just beyond 46 against the dollar early in the week, but did find support at lower levels and rallied back to the 45.60 area.

Risk appetite was very fragile early in the week as fears surrounding Egypt increased, but there was some recovery in sentiment following some evidence that overseas selling of domestic securities had eased.

There was relief surrounding the latest trade data as the deficit narrowed to US$2.6bn for December from US$8.9bn previously, but there were still inflation concerns, especially with rising energy costs. Dollar buying from oil importers was important in curbing demand for the currency.

The rupee should be able to resist substantial losses, but a significant recovery is unlikely given the potential for a deterioration in risk appetite.  

Hong Kong dollar:

The Hong Kong dollar found support close to 7.797 against the US dollar and rallied back to the 7.785 area later in the week. Trading activity declined sharply surrounding the Lunar New Year holidays.

The currency will again be hindered to some extent by a rise in US Treasury yields, although the impact will be offset by the Fed’s commitment to low short-term rates.

The Hong Kong dollar will lose ground when international risk appetite deteriorates, but substantial losses should be resisted given speculation over a stronger yuan.

Chinese yuan:

The yuan hit resistance stronger than 6.59 against the dollar with increased dollar demand blocking the central bank’s attempts to push the currency stronger. Activity halted from mid week with Chinese markets closed for the New Year holiday.

The official PMI reading weakened to 52.9 for January from 53.9, but there was a marginally higher reading for the HSBC reading. Markets continued to fret over potential inflation pressures and the risk that the central bank would need to take more aggressive action.

The central bank is likely to tolerate gradual yuan appreciation, but there is liable to be increased volatility over the next few months as capital flows intensify.

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