Weekly Forex Currency Review 13-06-2008

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Overall strategy: Market sentiment is likely to remain dominated by central bank attitudes towards interest rates and currencies in the short-term. The rise in US yields should provide further near-term dollar support, especially with scope for capital inflows, but it will still be difficult for the currency to make strong headway with the Euro underpinned by expectations of a near-term ECB tightening.                      

Key events for the forthcoming week

Dollar:

There will be some optimism over at least a limited rebound in the economy, especially after a stronger than expected retail sales report. There has been a significant shift in interest rate expectations and this will underpin the dollar as long as the Federal Reserve maintains a tougher stance on inflation and interest rates. Official comments on the US currency will also continue to be watched very closely in the near term and the dollar will benefit from more aggressive rhetoric in favour of a firmer currency. The US currency will still be vulnerable to renewed selling if the data suggests a renewed deterioration in conditions. 

The dollar was initially under pressure following the sharp unemployment increase to 5.5% from 5.0% reported at the end of last week. The US currency weakened to lows beyond 1.58, but then recovered strongly and re-tested levels beyond 1.54 later in the week. The US currency pushed to a one-month high on a trade-weighted basket.

The retail sales data was stronger than expected with a 1.0% increase for May after a revised 0.4% increase the previous month with sales probably boosted by the tax rebates. Elsewhere, jobless claims rose to 384,000 in the latest reporting week from 359,000 previously with some possible distortion from the Memorial Day holiday.

The pending home sales data recorded an increase of 6.3% for April after a 1.0% decline previously with some evidence of bargain hinting after recent falls in prices.

The comments from Fed officials were important during the week, Fed Chairman Bernanke stated that the Fed would strongly resist any erosion of inflation expectations while there were reduced risks of a substantial downturn in the economy which reinforced expectations of higher interest rates. Fed Governor Plosser also effectively called for an early increase in interest rates.

There were further comments in support of the US dollar with Treasury Secretary Paulson stating that he would not rule out the use of intervention.

There was a significant shift in interest rate futures with markets moving to price in at least two increases in the Fed funds rate by the end of 2008.

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There will be further expectations of an ECB interest rate increase at the July meeting. The beneficial impact to the Euro will be limited by a scaling back of expectations that the ECB will sanction a series of increases. There will be further unease over the economy, especially in Southern Europe and protests against the ECB policies are liable to increase while an Irish no vote would increase political stresses. There are also growing risks of further capital outflows from Europe which will tend to undermine the Euro.     
       
The Euro was strong in the first part of the week, but drifted generally weaker as there was some adjustment in ECB interest rate expectations.

The ECB maintained a tough stance on inflation during the week with a determination to prevent second-round effects. There were, however, suggestions that the bank would not look for a series of rate increases with ECB Member Stark suggesting that the bank would only look for a single increase at this time.

There were several comments warning over the impact of higher interest rates, notably from the Spanish and Portuguese government officials. There was some nervousness over the Irish Lisbon Treaty referendum result with some speculation that the Treaty would be rejected..

The economic data had only a limited impact with the industrial production data slightly stronger than expected while the Sentix index rose slightly for May.

Yen:  

The yield trends will remain negative for the Japanese currency and the increase in inflation will only have a positive yen impact if there is evidence of a shift in the Bank of Japan’s monetary policy which looks unlikely in the short-term. The yen will also lose support when risk appetite improves, but overall market conditions are likely to be volatile and there will be some capital flows back to Japan if there is a sustained downturn in stock markets. Overall, the yen should be able to resist heavy selling pressure from current levels.
                    
The Japanese currency remained on the defensive during the week, weakening to three-month lows around 108.0 against the dollar and 2008 lows against the Euro.

Core machinery orders rose 5.5% in April after two sharp monthly declines and there was a 0.5% annual increase. GDP growth for the first quarter was revised up slightly to 1.0% from 0.8% previously.

Wholesale price inflation rose to an annual rate of 4.7% in April from 3.7% the previous month which was the highest reading for 27 years.

The Bank of Japan left interest rates on hold at 0.50% following the latest council meeting while its assessment of the economy was also unchanged. There was no suggestion from the Bank of Japan that they would consider an increase in interest rates to stem the rise in inflation pressure.

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There will be further speculation over a deeper downturn in the economy, especially with the impact of a weakening housing sector and rising energy costs. There are clear inflation risks in the economy and the Bank of England will be forced to maintain a restrictive policy to combat inflation. In this context, yield support will continue and the UK currency could spike stronger if there is strong  speculation that rates will need to be increased. Nevertheless, the UK currency is unlikely to make strong headway given the lack of confidence in the economy. 
 
Sterling remained firmly on the defensive during the week, dipping to a four-week low against the US dollar near 1.94, while it was unable to make much headway against the Euro with consolidation around 0.7920.

The producer prices data was again substantially stronger than expected with a 3.8% increase in input producer prices for May to give a 27.9% annual increase which was the highest reading for over 20 years. There was also a strong rise in core output prices with the annual increase at a 20-year peak.

The housing data remained generally weak with the RICS survey reporting the lowest level of activity for 30 years, although there was a marginal recovery in the headline index with 92.9% of agents reporting lower house prices in May after a reading of 94.7% the previous month. The latest BRC survey recorded a recovery in retail sales with a 1.9% annual like-for-like increase in May.

The inflation data triggered a sharp increase in UK yields with markets speculating that the Bank of England would not have any scope to cut interest rates and could be forced to sanction an increase to control inflationary pressure. There was a sharp increase in inflation expectations to 4.3% from 3.3% in the latest quarterly survey

Swiss franc:

The Swiss currency will gain some support from speculation that the National Bank could decide on an interest rate increase, although they may opt for a steady policy at the June meeting. The franc will tend to lose ground when risk appetite strengthens with evidence of renewed interest in carry trades. There is a high risk that volatility levels will increase over the next few weeks as markets are trapped between expectations of higher yields and weaker global growth. Overall, there is scope for limited dollar gains from current levels.   
 
There was an increase in franc volatility over the week with the US currency finding support below the 1.02 level against the Swiss currency with selling resistance near 1.05. The franc edged stronger against the Euro, but was unable to break 1.60.

There were little in the way of domestic developments over the week, although there was a rumour that banking group UBS was set to announce further losses.

The National Bank concentrated on inflation risks in public statements over the week and there was some speculation that rates would be increased to combat inflation..

The Swiss franc lost ground at times on a shift into higher-yield currencies, but  gained some support from safe-haven demand as equity markets came under pressure.

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The Australian dollar hit tough resistance above the 0.96 level against the US currency during the week and dipped sharply to lows around 0.9320.

The domestic data was mixed with a sharp decline in consumer confidence to a 15-year low offset by a recovery in business sentiment while there was also a reported decline in home loans. The labour-market data was significantly weaker than expected with a 19,700 decline in employment for May while unemployment was at 4.3%.

The Australian dollar continued to fluctuate in line with moves in commodity prices and dipped sharply when gold prices came under pressure. Significantly, the currency struggled to regain ground when metals prices recovered.

The Australian dollar will remain vulnerable to a steeper correction given the risk of volatile commodity prices and increased doubts over domestic economic conditions. 

Canadian dollar:

The Canadian dollar weakened to lows beyond the 1.03 level against the US currency ahead of the central bank interest rate decision. The Bank of Canada left interest rates on hold at 3.00% following the latest council meeting compared with market expectations that there would be a further 0.25% rate cut to 2.75%.

In the monetary statement the central bank stated that the immediate downside risks to the economy had eased. The bank also stated that inflation risks had increased over the past few weeks. The currency strengthened to 1.0150 against the dollar following the rate decision, but was unable to sustain the gains.

The domestic economic indicators failed to have a significant impact on the currency over the week. The trade account remained in comfortable surplus for the month

Overall, the Canadian currency is likely to remain blocked on any rallies towards parity against the US dollar even with a shift in the Bank of Canada’s stance.

Indian rupee:

The rupee was generally on the defensive during the week, but central bank policy actions provided some degree of support to the local currency with evidence of buying interest close to the 43.0 level against the US dollar.

The central bank increased its principal lending rate by 0.25% to 8.0% which was the first increase for over 12 months. The positive rupee impact was limited by generally weaker sentiment towards Asian currencies.

The Indian currency was undermined initially by a renewed surge in oil prices before some slight relief later in the week as prices declined. There was still evidence of net capital outflows which unsettled the currency as overall sentiment remained weaker.

Overall, the rupee is unlikely to secure more than a limited recovery in the short-term given that the net capital account trends are liable to remain weaker.

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The Hong Kong dollar has remained weaker than the 7.80 central rate against the US currency and dipped to the lowest level since February close to 7.8140.

There was evidence of corporate demand for the US currency while wider demand for the US currency also tended to undermine the Hong Kong dollar. Underlying Asian currency sentiment has also been generally weaker over the past few days.

There was some recovery on Friday as there was a reduction in carry trade positions as local inter-bank interest rates increased.

The Hong Kong dollar should be able to resist losses from current levels against the US currency as arbitrage activity will dip, but it is liable to remain generally fragile. 

Chinese yuan:

The yuan secured net gains with a push to a fresh post-float high beyond 6.91 against the US currency even though the US dollar was generally firmer over the week. There was no widening of the forward premiums which suggested some market caution.

There were media reports that the consumer inflation rate had fallen to 7.7% in May from 8.8% the previous month, although underlying inflation fears persisted, especially as there was an 18.1% increase in M2 money supply over the year.

There was a stronger than expected 28.1% increase in exports in the year to May with a US$20.2bn trade surplus which also eased immediate fears over a sharp slowdown in export growth. The central bank was happy to maintain market uncertainty to help discourage speculative inflows and yuan volatility remained high over the week.

Overall yuan volatility is liable to remain high over the next few weeks. The net flows still suggest that net appreciation is realistic, although substantial gains look unlikely given a slightly firmer US dollar tone   

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