Weekly Forex Currency Review 08-04-2011

Overall strategy: The dollar remains generally out of favour and there will tend to be underlying central bank reserve diversification away from the US currency, especially with Asian countries in particular still resisting rapid currency appreciation which increases their dollar holdings. The US currency is, however, increasingly under-valued on a fundamental basis which will maintain the possibility of a sharp corrective rebound.

 Key events for the forthcoming week

Market analysis

Dollar: 

Monetary policy will remain a key short-term focus, especially with divisions within the Federal Reserve. There will be some pressure for a tighter policy, but the evidence suggests that Chairman Bernanke will resist demands for an early shift. The dollar will remain vulnerable to selling pressure on expectations that other countries will be more aggressive and there will also be further unease over the long-term fiscal position. The US currency is under-valued on a medium-term view and there will be unease over the global economy, especially as high oil prices will cause important stresses and damage growth. The US currency should, therefore, prove broadly resilient at current levels.

The dollar gained temporary support following firm employment data last Friday, but selling pressure on the US currency returned quickly and it retreated to fresh 2011 lows on a trade-weighted index as it was subjected to wider selling pressure.

The latest ISM non-manufacturing index was slightly weaker than expected at 57.3 for March from 59.7 the previous month and suggested that the sector might be slowing, but jobless claims declined and data releases overall were limited during the week. The dollar was unsettled to some extent by fears over a government shutdown.

The FOMC minutes were broadly in line with expectations as a majority were content to maintain the highly-expansionary policy. There were greater reservations from several regional Fed Presidents and these divisions are liable to increase over the next few weeks. Regional Fed President Lacker stated that a rise in US interest rates was possible before the end of 2011, but markets remain unconvinced that Chairman Bernanke is willing to follow this path.

In comments on Tuesday, Bernanke stated that inflation would be pushed higher by rises in commodity and energy prices. The comments were relatively brief, but Bernanke did say that the inflation rise should be transitory. These remarks again dampened market expectations that the Fed will push towards a more aggressive policy in the near term.

Asian central banks have also been aggressively preventing upward pressure on their currencies over the past week and a natural result from this is likely to be further reserve diversification away from the US currency.

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The Euro will continue to gain near-term support on interest rate grounds as the ECB takes a firm tone on policy. Some disappointment that the central bank did not take a more aggressive tone will be offset by hopes that further damage to the peripheral economies can be avoided. The Euro has proved resilient to structural fears even with Portugal applying for EU support and there will be important support from on-going reserve diversification. Markets will assess the contagion risk closely in the short-term as the Euro will be vulnerable to heavy selling pressure if there is any evidence of selling pressure spreading to Spain.

The Euro was subjected to some selling pressure during the week as support levels were tested, but there was always robust buying support on dips. The dollar was unable to gain significant traction and the Euro advanced to fresh 15-month highs at 1.44 in Asia on Friday.

Following another credit-rating downgrade, Portugal announced that it would seek Euro-zone aid as market funding became unviable following a further surge in yields at the latest bond auction. There are likely to be loans in the region of EUR60-80bn.

From a medium-term perspective the structural vulnerabilities will remain very important and there will be a particular focus on the potential contagion threat surrounding Spain. EU governments have done their best to promote the case that Spain has de-coupled from the Euro, but markets may not be convinced.

As expected, the ECB increased interest rates by 0.25% to 1.25% following the council meeting. In the press conference following the decision, President Trichet stated that policy was still very accommodative and that inflation risks would need to be monitored closely. He also stated that there was no decision at this stage whether there would be a series of rate increases.

The comments overall suggested that the bank would prefer to increase rates again, but that it will have to take a wait and see approach with no benefit from fuelling market expectations. The ECB maintained its commitment to providing unlimited liquidity through its money-market operations as there was a further delay in exiting from emergency measures.

The German economic data remained strong which provided underlying support for the currency, although this also illustrated powerful divergence within the Euro area. The lack of hawkishness from Trichet initially pushed the Euro weaker with a low just below 1.4250, but it regained ground quickly as the dollar crumpled again.

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From a medium-term perspective, there will be a continuing lack 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 also lose support when risk appetite improves with strong interest in carry trades. The Japanese currency will still gain support at times, especially as exporter selling will also increase at higher dollar levels.

The yen remained under pressure for much of the week and dipped to fresh 2011 lows near 85.50 against the dollar before finding some relief. There was a further increase in US Treasury yields which put upward pressure on the dollar.

The Bank of Japan left interest rates at the 0.00 - 0.10% range at the latest policy meeting and also announced that JPY1trn in loans would be made available to alleviate cash shortages following the earthquake. The yen gained some support from relief that an even more aggressive policy was resisted.

There was pressure for a yen correction after recent sharp losses and exporters were also taking advantage of the dollar’s rally and selling into strength. Brazil’s announcement of further measures to curb capital inflows sparked fears over reduced demand for emerging-market assets which also provided some yen support.

The latest Finance Ministry data recorded net buying of overseas bonds by Japanese investors following the March earthquake which will tend to dampen expectations of capital repatriation and this will tend to be a negative factor for the Japanese currency.

Sterling:

Recent economic data has been mixed and there is likely to be greater confidence over a strong first-quarter recovery in the economy. There will also be fears that underlying demand will continue to fade, especially with consumer spending under sustained pressure as real incomes decline and fiscal policy is tightened. The Bank of England is likely to increase interest rates slightly, but growth and debt fears will certainly restrain the central bank and interest rates are likely to remain negative in real terms which will be a negative Sterling influence. The currency will find it difficult to make much headway and will be vulnerable to heavy selling if banking fears intensify again.

Sterling found support below the 1.60 level against the dollar following the US payroll data late last week and the currency gradually pushed higher to re-challenge 2011 highs as the US currency remained under pressure. The Euro found it hard to stay above the 0.88 level.

The PMI services index rose to 57.1 for March from 52.6 the previous month. This was a 13-month high for the index and much stronger than expected, although business optimism did actually decline slightly.

The other data was mixed as there was a sharp 1.2% decline in UK industrial production for February following a revised 0.3% increase previously while manufacturing output stalled. The Halifax house-price index was marginally lower than expected with a 0.1% monthly increase for March.

The Bank of England left interest rates on hold at 0.50% and also held quantitative easing at GBP200bn. This was the expected outcome, although there had been some speculation over a hike and the UK currency weakened following the announcement.

There was no statement and the vote split will not be released for 2 weeks when the minutes will be published. The next focus will be on inflation pressures with the producer prices data due to be released on Friday followed by the consumer inflation data on Tuesday.

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Domestically, there will be increased pressure on the National Bank to tighten monetary policy following higher than expected inflation data. The bank will remain sensitive to competitiveness issues and will be reluctant to tighten in the near term which will have some negative franc impact, particularly as the ECB has already tightened. The franc will be used as a global funding currency at times and defensive demand will fade when risk appetite is strong. There is still the potential for defensive inflows given the Euro-zone structural fears and volatility will remain an important threat.

The franc dipped sharply at times during the week, but generally proved to be resilient and the Euro despite wider interest-rate differentials and also advanced back to the 0.91 area against the franc.

The improvement in risk appetite and a surge in carry-trade activity will continue to lessen potential defensive franc demand in the short-term. Although there has been further evidence of capital flows from weaker European economies, there has been an increased flow into emerging markets rather than the franc.

The latest Swiss consumer inflation data was much stronger than expected with a 0.6% monthly increase for March. The strong inflation data will increase pressure for the National Bank to increase interest rates, especially as rising inflation has come at a time when franc strength has been holding down import costs.

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 1.05 as sentiment remained extremely strong with strong-buying support on dips. The currency drew support from the high level of commodity prices and strong international interest in carry trades.

The latest employment data remained strong with an increase in employment of over 37,000 for March, but there was a further sharp decline in the housing sector and the PMI business surveys also weakened sharply.

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 resisted profit taking attempts during the week and pushed to fresh 3-year highs beyond 0.9550 against the US dollar. There was further support from generally very high commodity prices and the strength of energy prices.

The domestic data releases had only limited impact, butt here was some speculation over a more aggressive Bank of Canada tone at next week’s monetary policy meeting.

The Canadian dollar will continue to draw support from the high level of commodity prices, but valuation issues will make it vulnerable to a sharp correction.

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The rupee maintained a strong tone during the week and pushed to the highest levels for close to six months with a peak near 44 against the US dollar even though oil prices remained at extremely high levels.

The US currency was generally fragile which supported the rupee. There was additional support from merger-related flows and there was also further evidence of overseas capital inflows into the local stock market which boosted sentiment.

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 maintained a strong tone during the week and strengthened to test resistance beyond 78 against the US dollar.

Risk appetite remained generally stronger which helped underpin the currency as capital inflows increased while IPO-related inflows also provided support.

The Hong Kong dollar will gain further support from capital inflows and speculation that there will eventually be a break of the US dollar the currency peg.

Chinese yuan:

The yuan has maintained a strong tone during the past week and pushed to a fresh post-float high close to 6.54 against the dollar on Friday as the central bank continued to tolerate advances.

The Chinese central bank increased interest rates with the benchmark lending rate rising 0.25% to 3.25% as inflation fears persisted.

There was further speculation that the authorities would tolerate a faster rate of currency appreciation in order to help dampen inflationary pressures.

The evidence continues to suggest that the central bank will sanction gradual yuan appreciation to curb inflation and boost medium-term consumer spending trends.

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