Weekly Forex Currency Review 19-09-2008

Overall strategy:

Markets will continue to focus heavily on financial-market conditions amid still very serious underlying stresses.  It will be difficult to secure a sustained improvement in risk appetite even with the US rescue agency plans. The dollar will continue to gain defensive support from a reduction in net capital inflows into emerging markets. Nevertheless, overall fundamental weaknesses suggests limited scope for gains, especially with greater pressure on the Federal Reserve to maintain a very loose monetary policy.

Key events for the forthcoming week

Dollar:

The severe financial-market stresses will tend to remain dominant for now. The US currency will gain some support on defensive grounds with a repatriation of investment flows. The Federal Reserve will have to maintain a loose monetary policy to help provide protection which will reinforce the lack of yield support. There will be renewed doubts over US economic trends which will also tend to undermine sentiment.  From a medium-term perspective, the US fiscal position is also liable to deteriorate which will pose important dollar risks. Hopes for a resolution to the financial crisis should offer some short-term dollar backing.

Conditions and developments within the US and global financial sector continued to dominate market sentiment with intense volatility. The dollar weakened in the middle of the week, although it recovered strongly from its worst levels and gained ground on Friday as market fears eased with gains through 1.42 against the Euro.

Investment bank Lehman Brothers was forced into bankruptcy after it failed to secure a private-sector deal and the government refused to provide support. In contrast insurance group AIG was given a US$80bn bridging loan from the Federal Reserve to stave off collapse. In return the Fed took an 80% stake in the company.

The US currency secured some defensive support as there was a flight to Treasury bonds with yields falling to extremely low levels. There was also evidence of a flow of funds out of emerging-market currencies which supported the US currency.

There were serious tensions within the money markets as banks remained very reluctant to sanction inter-bank lending. Global central banks injected near US$200bn of liquidity into money markets in an attempt to stabilise conditions.

Following the series of bailouts, there were greater fears over the US fiscal situation and there were some warnings that the US sovereign credit rating could be in jeopardy in the medium term. Immediate confidence rebounded on Friday as US authorities met to debate plans for an agency which would buy illiquid holdings from the banks.

The US Federal Reserve held interest rates at 2.0% following the latest policy meeting. The statement was generally balanced with unease over inflation offset by a statement that the economy appeared to have deteriorated over the past few weeks.

The economic data tended to be of secondary importance given the focus on financial markets, although there were important releases. There was a further decline in housing starts to the lowest level for over 17 years while building permits also weakened further over the month.

The industrial data was mixed with the New York manufacturing index falling back to below zero according to the September survey, although the Philadelphia Fed index recovered. There was also a 1.1% decline in industrial production for August, undermined in part by a sharp decline in utility output. Initial jobless claims also increase to 455,000 in the latest week from 440,000 previously.

Consumer prices fell by 0.1% in August while there was a core increase of 0.2% to give a 2.5% annual rate. The latest capital account data was weaker with net long-term inflows of US$6.1bn for July while there were net outflows of overall capital.

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Confidence in the Euro-zone economy will remain weak in the short-term with expectations of a further deterioration in conditions. The ECB remains committed to a tough inflation stance, but there will be speculation that the central bank will cut interest rates relatively quickly to ease the financial and economic strains. Overall, the European fundamentals should hold firm in relation to the US which should provide some underlying Euro protection.                 
       
The Euro struggled to sustain gains over the week and the overall performance was still not entirely convincing with a diversity of performance in erratic trading.

There was a recovery in the latest German ZEW economic sentiment survey, although the impact was offset by fears over renewed pressures in the financial sector.

The ECB maintained a firm tone in pubic comments with a particular focus on the need to avoid second-round inflation effects. The bank is uneasy over the outlook for wage settlements with a particular focus on key unions such as IGMetall.

Overall confidence in the Euro-zone economy remained weak with a particular focus on Spain and Italy as market conditions remained very tense.

Yen:  

International trends will tend to dominate in the short-term and the Japanese currency will gain important defensive support. Risk tolerances will remain lower while there will be the threat of near-term capital repatriation.  Japanese banks should also remain less vulnerable to credit disruptions.  Confidence in the domestic economy will remain weak in the short-term which will curb yen support and a sustained improvement in risk conditions would undermine the currency. Nevertheless, the yen should be able to resist heavy losses.
                   
The Japanese currency secured important defensive support as risk aversion increased sharply. The yen gained strongly following Lehman's collapse with a move to 103.50 against the dollar and a peak near 147 against the Euro.

The yen failed to hold the best levels as markets attempted to stabilise and the US plan to form a new bad-debt agency pushed the yen significantly weaker on Friday with lows around 107 against the dollar.

The Bank of Japan left interest rates at 0.50% at the latest policy meeting and remained cautious over the domestic economic outlook. In order to ease market stresses, the Bank of Japan and added dollar liquidity to the markets for the first time.

The monthly Tankan index recorded a further deterioration in the services sector with a decline to a five-year low, although there was a slight recovery in manufacturing.

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Confidence in the domestic economy will remain extremely fragile in the short-term as recession fears persist. There will be strong pressure on the Bank of England to cut interest rates as soon as possible to ease conditions. The quick resolution to the HBOS situation will help ease immediate fears surrounding the financial sector and the Bank of England will want to take a firm stance to curb inflation expectations. The deteriorating global situation should also help provide some degree of Sterling protection on relative grounds.

Following heavy selling pressure over the past three weeks, Sterling was able to regain some composure, although volatility remained very high. Sterling recovered to 0.79 against the Euro with a peak above 1.82 against the dollar before renewed losses.

Domestic and international financial-market trends remained important over the week. HBOS shares were sold very heavily on fears that the company was facing a collapse and this triggered a rescue bid for the company by LloydsTSB. The Bank of England also announced that its liquidity support measures would be extended.
 
The latest Bank of England minutes recorded a 8-1 vote for unchanged interest rates at the September meeting with Blanchflower calling for a 0.50% rate cut. The bank had discussed all policy options and was uneasy over the impact of Sterling weakness.

The employment data remained weak with a sharper increase in unemployment of over 30,000 in August after a revised 27,000 increase the previous month. In contrast, the retail sales data was stronger than expected with a 1.2% increase for August, although gains were likely to have been led by price discounting.

The headline consumer inflation rate rose to a 16-year high of 4.7% in August from 4.4% the previous month while the core rate increased to 2.0% from 1.9%.

Swiss franc:

The Swiss economy will continue to slow with reduced domestic and export activity. The National Bank decision to hold interest rates steady will provide some degree of reassurance over near-term trends. The financial-market trends will be watched very closely, especially as there will be increased fears over the outlook for the Swiss banking sector. While the franc will gain near-term defensive support on elevated risk aversion, the currency could be subjected to heavy selling pressure if difficulties within the domestic banking sector intensify.       

The franc maintained a firm tone against the Euro as risk aversion remained high and also strengthened to highs around 1.09 against the dollar. The franc weakened from its best levels as global stock markets recovered strongly late in the week.

The economic data provided some support with a recovery in the ZEW survey. There were also solid increases in the retail sales and industrial production data. There were concerns over the banking sector as UBS shares fell sharply before a late recovery.

At the quarterly policy meeting, the National Bank held interest rates at 2.75%. The bank also retained its 2008 growth and inflation forecasts. The bank took a generally firm tone against the inflation which provided near-term currency support with Bank Chairman Roth generally confident over the outlook.

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The Australian dollar was generally weaker, although the principal feature was a sustained increase in volatility. The currency found support close to the 0.78 level against the US currency and pushed back above the 0.81 level on Friday.

The currency came under pressure when there was an increase in risk aversion, especially as confidence in the regional economy deteriorated. The impact was mixed, however, as the currency drew some support from a strong rally in gold prices.

Domestically, the Reserve Bank confirmed the shift to an easier monetary policy bias, although it suggested that interest rates would not be cut quickly.

The near-term Australian dollar moves will remain strongly correlated with levels of risk aversion and a further limited recovery is realistic in volatile trading.

Canadian dollar:

The Canadian dollar found support close to the 1.08 level against the US dollar and strengthened to 1.065 in choppy trading conditions. Industrial commodity prices were generally under pressure, but gold rose very strongly which provided net support.

The domestic data had only a limited impact with a robust increase for wholesale sales. In contrast, significant investment outflows increased unease over the underlying capital account trends. Markets continued to price in a series of interest rate cuts by the central bank.

Trends in risk aversion will continue to be an important short-term focus for the Canadian dollar. Fears over the global growth outlook will limit the scope for gains.

Indian rupee:

The rupee remained under pressure for much of the week and dipped to a 24-month low around 47 against the US dollar. There were further important domestic and regional market stresses which undermined the currency with a continuing outflow of capital on global de-leveraging and a retreat from emerging markets.

Market conditions stabilised later in the week as central banks boosted liquidity and there were hopes for a US rescue plan. This helped curb rupee selling and there were suggestions of central bank support for the currency with a recovery to 46.35.

Confidence in the economy and region is liable to remain very fragile. In this environment, the rupee will find it difficult to regain much ground.

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The Hong Kong dollar strengthened over the week and peaked close to 7.78 against the US currency. US money-market rates fell sharply and this undermined the US currency as arbitrage activity declines sharply.

Overall confidence in the region was still fragile as stock markets remained under pressure. The financial authorities pledged that there were no plans to support the local market. The HKMA injected liquidity into the market which helped bring money market rates down and stabilised the currency near 7.7840 on Friday.

Overall, the Hong Kong dollar will struggle to extend gains, especially as underlying regional capital inflows are liable to remain weaker on economic doubts.

Chinese yuan:

The yuan edged slightly stronger against the dollar over the week, although it struggled to make much headway with the central bank promoting stability.

There was a significant shift in domestic policy as the central bank switched to an easier policy. There was a 0.27% cut in official interest rates while the bank also lowered the 28-day repo rate for the first time this year.

The Chinese stock market remained under consistent selling pressure and the authorities pledged that they would take direct action to support he market. This triggered a rally of close to 10% in the local market on Friday.

Unease over the domestic and regional economic trends will continue to limit the extent of speculative capital inflows. The central bank will still be looking to promote stability which should limit the extent of yuan depreciation.  

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