Weekly Forex Currency Review 08-07-2011

The Euro-zone will remain an extremely important focus over the next few weeks at least Although there will be periods of relief, the underlying stresses are liable to persist with the Euro still at high risk given the underlying debt structure. There will be further unease surrounding the global growth outlook with a particular focus on the Chinese prospects as debt and inflation uncertainties increase.  

Key events for the forthcoming week

Market analysis

Dollar: 

There have been mixed US economic data over the past week with some relief over stronger than expected employment releases, although the payroll data will be pivotal for any durable rebound in confidence. There will still be expectations that the Federal Reserve will maintain interest rates at extremely low levels. The US debt-ceiling talks will be monitored closely as further speculation over a debt default would put the US currency under strong selling pressure. International considerations will remain extremely important and there will be defensive dollar support from fears over the Euro-zone and from unease over a slowdown in the global economy. Overall, there is scope for limited dollar gains.

The dollar gained support at times from stresses within the Euro-zone, especially when risk appetite also deteriorated, but it found it difficult to sustain gains as underlying confidence in the currency was still weak and the trade-weighted index only made limited headway.

The ISM index for the services sector was weaker than expected with a decline to 53.3 for June from 54.6 the previous month, reinforcing expectations of slow growth within the economy. There was a sharp deterioration in orders and prices for the month while the employment index held steady. Overall, the report reinforced expectations of subdued growth.

The US labour-market data was stronger than expected with an increase in ADP private-sector employment of 157,000 for June from a revised 38,000 previously while there was also a decline in jobless claims to 418,000 from 432,000.  The data triggered some optimism over Friday’s pivotal US employment release and there was also speculation over a near-term agreement on raising the debt ceiling following protracted negotiations during the week. There were no major comments on monetary policy during the week.

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The Euro-zone debt crisis will continue to be watched very closely in the short-term, especially given the contagion risks surrounding peripheral economies as the authorities have been unable to contain the rise in yields. There is also still a high risk of a Greek debt default in the medium term while the banking sector will remain vulnerable. There will be initial yield support for the Euro following the ECB increase and relatively hawkish method, but support may be transitory given fears that there will be additional downward pressure on the weaker economies. It will still be difficult for the Euro to gain sustained support given the structural vulnerabilities.

The Euro was capped around 1.4550 against the dollar and came under further selling pressure during Wednesday as Euro-zone sovereign-debt fears increased again following Portugal’s rating downgrade by Moody’s. There was a further widening of yield spreads with Portugal’s benchmark 10-year benchmark yields rising to over 10% above German bonds as there was forced selling from institutions.

Following talks surrounding the Greek private-sector debt roll-over plans, IIF head Dallara stated that any solution to Greece’s problems could involve a temporary default and there was also evidence that roll-over participation would be limited as many institutions had already sold their bonds. More positively, Moody’s stated that it would differentiate between peripheral countries which could spare Ireland from immediate action. There were still fears of a widening contagion effect with rumours that Italy could be downgraded and unease surrounding the Spanish banking sector.

There was no surprise with the ECB interest rate decision with a 0.25% increase in the benchmark repo rate to 1.50% and the deposit rate was also increased. In the press conference following the decision, President Trichet stated that policy was still accommodative and that there were upside risks to inflation. These comments were very similar to those seen following the April interest ate increase and suggested that the central bank was expecting to increase rates again later this year.

In response, the Euro advanced strongly to the 1.4370 area with a covering of short positions taken in anticipation of a more dovish Euro tone. The ECB also announced that it would abandon collateral requirements for Portuguese banks looking to borrow from the ECB. Such a more was necessary following the downgrade of Portugal’s credit rating to junk status and will prevent an immediate liquidity crisis.

The German constitutional court also started its hearings into the legality of German contributions to a Greek rescue fund on Tuesday which will add to the mood of uncertainty. The Euro-zone economic data provided some degree of relief with a rise in the Sentix index for the month, although this was over-shadowed by underlying fears surrounding the sovereign-debt outlook and European financial sector.

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There will be some optimism over a very slow improvement in the economy as production and supply lines recover gradually from the earthquake-induced damage.  There will be concerns over the Asian growth outlook which will tend to curb selling pressure on the Japanese currency. There will also be the potential for capital repatriation from Europe given stresses within the financial sector. The yen is still close to the pivotal 80 level against the dollar which will maintain the potential for verbal intervention.  

The dollar found support on dips to near the 80 level during the week and advanced sharply to highs around 81.40 early in US trading on Thursday before a phase of consolidation. There was still a reluctance to sell the yen aggressively given unease over the Euro-zone debt profile.

The dollar gained support from a rise in Treasury yields following the ADP jobs data, especially as there was also greater optimism surrounding the Friday payroll release. Underlying risk appetite also held firm which curbed defensive demand for the yen. There was still some unease over the threat of capital repatriation from European bond markets and Asian growth doubts also curbed yen selling.

Domestically, bank lending remained weak with a 0.6% annual decline, maintaining fears over underlying lending conditions while there was a decline in the current account surplus to JPY0.39trn from JPY0.55trn previously.

Sterling:

Confidence in the economy will remain weak with further concerns over the outlook for consumer spending. The Bank of England has again held interest rates on hold at 0.50% and expectations of a loose monetary policy over the next few months will continue to undermine Sterling yield support. Any further escalation in strike activity would also undermine confidence in the outlook and spark speculation over a shift in government policies. Sterling will also tend to lose support if there is any deterioration in risk appetite, especially as UK bank-sector vulnerability would become a greater focus.

Sterling remained generally vulnerable during the week and tested support beyond 0.90 against the Euro before a partial recovery while there was also a retreat to below 1.60 against the dollar.

The PMI services-sector index edged higher to 53.9 for June from 53.8 previously. Although only slightly stronger than expected, the data did help stem near-term pessimism towards the economy and there was a covering of short positions.

There was also a 0.9% rebound in UK industrial production for May following the sharp decline previously and the manufacturing data was stronger than expected which provided relief. Less positively, the NIESR estimated that GDP growth slowed sharply in the three months to June to 0.1% from 0.5% previously which maintained concerns over a weak economy.

As expected, the Bank of England left interest rates on hold at 0.50% following the latest MPC meeting. There was no statement with the decision and the vote breakdown will not be known for two weeks. Markets overall will be expecting very low interest rates to continue over the next few months which will also continue to leave Sterling vulnerable on yield grounds, especially after the ECB rate hike.

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The franc did weaken following the Greek austerity package deal, but quickly regained ground and it will continue to be influenced very strongly by degrees of risk appetite within global markets. An underlying lack of confidence in the Euro-zone will continue to provide net support.  The currency is substantially over-valued and any aggressive move by the National Bank on quantitative easing could trigger sharp losses for the currency with volatility set to remain at elevated levels in the short-term.  

The dollar found support below 0.84 against the franc and rallied sharply to a peak near 0.85 during Thursday before retreating again in very choppy trading conditions. The Euro fell sharply over the first half of the week with a move back to 1.20 against the Swiss currency following Portugal’s credit rating downgrade. 

There was a reversal following the ECB decision as the Euro rallied back to above 1.21 against the Swiss currency following Trichet’s testimony and a widening in Euro yield support.

The firm ECB tone will reinforce the franc’s lack of yield support but there will be further defensive inflows if fear over Euro-zone peripheral economies increases again. The main feature is liable to be consistently high volatility as large-scale fund flows clash with relatively low liquidity. The government continued to state that the franc was over-valued, but ruled out capital controls.

Australian dollar:

The Australian dollar was confined to narrower ranges for the week as a whole with the currency continuing to gain strong support on dips and regaining the 1.07 level.

Despite unease surrounding the Euro-zone debt situation, risk appetite held firm for the week as a whole and the Australian dollar also rallied quickly from a sharp retreat following China’s decision to increase interest rates.

Domestically, the Reserve Bank of Australia left interest rates on hold at 4.75%. There was a more cautious attitude surrounding the economic outlook with the bank maintaining a mildly restrictive tone. The latest employment data was stronger than expected with a 23,700 increase in employment for June. In contrast, the retail sales and building permits data was weaker than expected.

The domestic and international risk profile suggest that the Australian dollar will find it difficult to advance from current levels with housing a notable focus.

Canadian dollar:

The Canadian dollar maintained a firm tone during the week as a whole with the US currency unable to sustain advances as risk appetite also stabilised. The Canadian currency drew support from optimism over the local economy and further speculation over an increase in interest rates during the third quarter .

Domestically, the building permits and PMI data were significantly stronger than expected which provided support and the Canadian dollar advanced to highs beyond 0.96 against the US dollar.

The Canadian dollar could gain further near-term support on optimism surrounding the domestic economy, but is unlikely to make strong gains from current levels.

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The rupee was able to resist selling pressure during the week and generally held firm in a 44.30-44.50 range against the US dollar. There was a firm tone in the local stock market which helped underpin confidence with estimates of overseas capital flows of US$2.2bn over the past seven trading sessions.

Evidence of inflows also boosted confidence, offsetting uncertainties surrounding regional growth which supported the rupee. There was also optimism surrounding potential capital inflows associated with the forthcoming ONGC flotation.

The rupee should be able to remain resilient given hopes for equity-related capital inflows. It will be difficult to make significant gains given regional uncertainties.

Hong Kong dollar:

The Hong Kong dollar was unable to strengthen through the 7.78 level against the US dollar and was generally trapped within narrow ranges.

There was a stabilisation in risk appetite which provided support, but there was also unease over the mainland Chinese economic outlook which deterred significant buying support for the currency.

The Hong Kong dollar will gain support when risk appetite improves, but the theme of uncertainty surrounding local economic trends will limit any potential advance

Chinese yuan:

The Chinese yuan maintained a solid tone for the week as a whole and there was a record-high fixing at 6.465 before a slow retreat over the second half of the week. The central bank announced a further 0.25% increase in interest rates with the lending rate increased to 6.56%

The release date of the latest consumer inflation data was brought forward amid strong expectations that the rate would increase to above 6.0%. Internationally, there was further speculation over rising bad debts within lending to local government and there was increased uncertainty surrounding the growth outlook.

Although slow yuan appreciation remains likely for now, there will be a growing threat of instability as fears surrounding the Chinese economy are liable to increase.