Weekly Forex Currency Review 11-06-2010

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The global budget deficit trends will remain important in the short-term as sovereign debt developments will continue to be watched very closely with any downgrades having an important negative impact on currency sentiment. Official exchange rate policies will also be watched very closely as there will be speculation that governments will look for weaker currencies to help underpin economic recoveries with the risk of competitive devaluations over the next few months, especially if growth falters.

Key events for the forthcoming week

Dollar:

The US economic data has not provided any fresh support for the dollar and any evidence of a more serious reversal in trends towards recovery would undermine yield support. There will also be very important doubts surrounding the US fundamentals, especially given the substantial trade and budget deficits. In this environment, the US currency will tend to remain dependent on defensive demand to make much headway. Although international confidence will rally at times, the net risks suggest that underlying sentiment will be fragile which will help limit dollar losses.

The dollar gained strongly at the end of last week following the US employment data. The headline data was weaker than expected with an increase of 431,000 in employment for May which was the highest increase for over 10 years. A very high proportion of the gains were due to government hiring for the census and the increase in private-sector payrolls was limited to 41,000 compared with expectations of a 190,000 gain. The data may cast some doubts over the strength of the US economy.

Jobless claims only fell marginally to 456,000 in the latest reporting week from a revised 459,000 previously which suggests that labour markets are still relatively weak. The trade deficit rose to a 16-month high of US$40.3bn for April while the May budget deficit remained firmly in deficit.

Volatility remained a key factor, but market fears eased to some extent during the week and this curbed defensive dollar demand. The US currency drifted weaker against European currencies while it held steady against the Japanese currency.

In testimony to Congress, Federal Reserve Chairman Bernanke stated that the economy was improving with gains in private demand. He did, however, also state that the recovery was modest and there was no suggestion in the rhetoric that the Fed was looking for a near-term policy tightening.

The Fed’s Beige book recorded gains in all 12 Fed districts which maintained some degree of optimism over the economy, but there was still an element of caution, especially surrounding investment.

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Underlying confidence in the Euro-zone economy and Euro will remain very fragile with persistent doubts whether the Euro area will survive in its current form.  From a longer-term perspective, a further orderly currency decline is unlikely to meet serious opposition, especially as the currency could still be considered over-valued and further losses are certainly realistic. G7 policy-makers will, however, be alarmed over the pace of recent declines and it is also the case that will be scope for sharp rallies at times on position adjustment.

The Euro remained under heavy pressure early in the week. There were reports that the French Prime Minister had stated that Euro at parity against the dollar would be good news. These comments were denied, but there was still an important loss of confidence in the Euro.

The new Hungarian government also warned over potential default and claimed that the previous administration had issued false information.

Sovereign debt issues remained a key market focus while there were fears that weaker members could be forced to withdraw from the Euro area. The evidence suggested that policy-makers remain uneasy over the pace of the Euro’s decline, but also that there are no significant concerns over the currency’s level. In this environment, there were market expectations that the Euro would weaken further in the medium term.

As expected, the ECB left interest rates on hold at 1.0% following the latest council meeting. Principal attention focussed on the special policy measures and the central bank press conference following the meeting. There were no additional liquidity measures announced by and Bank President Trichet stated that the measures enacted so far were strictly temporary in nature and did not represent quantitative easing. Trichet also commented that the Greek budget deficit appeared to be on track for the first five months of the year.

Trichet’s comments were clearly designed to bolster confidence in the Euro-zone economy and Euro while providing reassurance to global investors. There was a short-term favourable Euro reaction on the comments while the currency also gained traction from an improvement in risk appetite.

There were successful bond auction which helped underpin confidence to some extent as yield spreads within the Euro area narrowed and the currency recovered to above 1.21 against the dollar from initial lows below 1.19.

Yen

There will be further expectations that the government will look to block any yen gains, especially as domestic and international underlying confidence in the Japanese fundamentals will remain very weak.  The yen will also tend to lose ground when risk appetite improves, especially with a lack of yield support. Overall confidence in the global economy is still likely to be very fragile and the risk profile still suggests that heavy yen selling is unlikely as there will be a reluctance to sell the currency aggressively.

The yen found it difficult to sustain gains during the week. Risk appetite managed to stabilise during the week with confidence in the global economy boosted by confirmation of a strong Chinese export performance for May. There were also renewed gains for the Australian dollar which helped sustain interest in carry trades and tended to weaken the yen.

Domestically, an annual rise in wholesale prices and firmer consumer confidence could have a small positive yen impact, but the impact is likely to be limited. Core machinery orders rose 4.0% in the latest month which was below market expectations and structural fears surrounding the Japanese economy remained an important feature.

The latest domestic banking-sector data recorded a 2.0% decline in lending in the year to May which will maintain expectations that Japan will need robust export growth to offset the impact of very weak domestic demand and credit. There were further expectations that the government would resist any significant yen appreciation.

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The inter-play between government budget trends and the Bank of England monetary policies will remain extremely important over the next few months. There is scope for greater confidence in an orderly deficit-reduction programme which will ease immediate credit-rating fears. The fiscal tightening will increase pressure for interest rates to be left on hold and this will leave Sterling exposed to potential inflation fears. Underlying confidence is likely to remain very fragile and fears could return quickly even if there is a near-term Sterling advance.

Credit-ratings agency Fitch warned that the UK government faced formidable challenges over fiscal policy and that speedy cuts in spending levels were required to stabilise the deficit. To some extent the report held no new information as the government had already warned that there needs to be greater than expected spending cuts. The remarks still triggered significant selling pressure with Sterling losses to important support levels close to 1.4350 against the dollar before a tentative rally.

The Bank of England left interest rates on hold at 0.50% following the latest MPC meeting and there was no expansion of the quantitative easing programme. The bank also decided not to issue a statement and this will tend to curb Sterling support to some extent as the bank is likely to warn markets over a potential rate increase. The lack of comments suggest that the bank is not looking for an immediate rise in rates.

The underlying fiscal and monetary policy mix will remain unfavourable for Sterling, but it continued to gain important support from a lack of confidence in the fundamentals elsewhere.

As international risk appetite stabilised and there was some merger-related Sterling demand the currency rallied to highs above 1.47 against the dollar while it held near 18-month highs against the Euro stronger than the 0.83 level.

Swiss franc:

The franc will continue to gain defensive support from a general lack of confidence in the Euro and Euro-zone economy. The National Bank policies will remain under very close scrutiny in the short - term, especially as recent policy actions have appeared inconsistent. There will continue to be pressure on the bank to curb excessive currency appreciation within Europe to help maintain competitiveness, although recent losses against the dollar will tend to ease deflation fears which will lessen pressure.

The dollar was unable to hold gains above 1.17 against the Swiss franc and weakened to lows near 1.14 due to a firm Swiss currency and some loss of US support. There was further volatility against the Euro as National Bank policies remained important.

The Euro weakened to fresh record lows near 1.3750 against the Swiss currency before finding support and rallying back to around 1.3850.

There was evidence of central bank intervention, but there was a high degree of confusion over the policy stance as it was unable to deliver a coherent message.

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The Australian dollar was subjected to substantial selling pressure following the US employment data at the end of last week while selling continued early in the week. There was support on dips towards the 0.80 level and the currency rallied strongly later in the week with highs back near the 0.85 area.

The domestic data recorded a decline in home - loan demand while Reserve Bank Governor Stevens was generally cautious over the outlook, but the overall impact was relatively limited and another robust monthly employment report provided support.

The Australian currency drew support from a measured improvement in risk appetite while robust Chinese export data also provided some degree of support.

The Australian dollar moves will be influenced strongly by trends in risk appetite and degrees of optimism over the world economy. Volatility is liable to remain higher and the currency will find it difficult to make much strong headway.

Canadian dollar:

The Canadian dollar again found support weaker than the 1.06 area against the US dollar and strengthened to highs beyond 1.04. Trends in risk appetite remained important with the currency gaining renewed support when stock markets and commodity prices rallied.

There was a weaker than expected housing starts report, but there was still underlying confidence in the fundamentals which offered important underlying currency support.

Volatility levels are liable to remain higher in the short-term and the Canadian dollar will find it difficult to advance much further given the global risks.

Indian rupee:

The rupee weakened to lows near 47.50 against the dollar during the week before a recovery back through 47 later in the week.

Trends in risk appetite remained very important for the currency and there was selling pressure as global equity markets declined with some net capital outflows. Confidence generally recovered later in the week and there was also some evidence of corporate dollar selling which helped underpin the currency.

Despite losses when international risk appetite deteriorates, the rupee should be able to maintain a solid tone given underlying optimism over the fundamental outlook.

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There was a further decline in Hong Kong dollar volatility during the week with support stronger than the 7.80 area against the US dollar.

There was a stabilisation in risk appetite during the week which helped underpin confidence to some extent.

The Hong Kong dollar trends will be influenced by developments in risk appetite and substantial losses look unlikely even if there is little prospect of a strong advance.

Chinese yuan:

The spot yuan rate remained trapped in a narrow range while the Chinese currency also reversed some recent gains against the Euro.

The latest trade data was stronger than expected with annual export growth of close to 50% . There were still some concerns over the impact of a stronger yuan over the second half of 2010 and there were official reservations over and policy changes.

There was renewed international friction over the yuan’s exchange rate with US Treasury Secretary Geithner stating that China’s exchange rate policies were hampering a balanced global economic recovery.

Fears over global market volatility and doubts over the economic outlook may ease slightly in the short -term, but there will still be reservations over any major changes to the yuan’s exchange rate mechanism in the short-term.