Weekly Forex Currency Review 22-05-2009

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The dollar has shown important signs of increased vulnerability over the past two weeks with increased fears over the medium-term debt outlook and there will be underlying fears over the issue of reserve diversification. There are still important weaknesses in all the major economies and this should help limit US currency losses even if it remains on the defensive in the short-term.      

Key events for the forthcoming week

Dollar:

Underlying confidence in the US fundamentals will remain fragile with continuing fears that an escalating debt burden will result in a longer-term credit-rating downgrade which would be very damaging for the currency.  These fears will tend to be increase after the Standard &Poor’s move to put the UK on credit watch. The further narrowing in credit spreads will also tend to limit defensive demand for the US dollar.  There is still the potential for dollar gains if global fears intensify again and weak fundamentals elsewhere should limit losses.    

 
The dollar failed to make any impression against the major currencies and then weakened sharply with the trade-weighted index dipping to 5-month lows as there was substantial selling pressure on the currency.
The Libor fixing rates recorded a sharp drop in 3-month dollar rates to 0.66% from 0.83% last week while the TED and Libor-OIS spreads also continued to narrow to 15-month lows. Libor rates have fallen consistently during May from levels above 1.0% and the decline indicates that there has been a significant easing of stresses. 

Any sustained improvement in conditions would suggest increased dollar supply in markets and reduced demand for the currency. This combination would certainly tend to limit the scope for dollar gains and increase the risk of selling pressure.

US Treasury Secretary Geithner stated that the financial system was starting to heal which also reinforced the mood of greater optimism towards the global economy.

The US housing data was weaker than expected with starts falling to an annual rate of 0.46mn for April from a revised 0.53mn the previous month. This was a record low for the series and building permits also fell to below the 0.50mn level. Starts were dragged lower by notable weakness in the apartments sector and single-family starts were more robust which will help cushion the impact of weak headline data.

The Philadelphia Fed index improved to -22.6 in May from -24.4 the previous month, but there was some disappointment that there was not a bigger improvement. Similarly, initial jobless claims only fell to 631,000 in the latest week from 643,000 previously while continuing claims increased to a fresh record high at 6.66mn.

There was significant selling pressure in US Treasuries due in part to unease over the medium-term debt and inflation outlook as the massive US debt issuance continues. Following the Standard & Poor’s warning over the UK debt rating, there were some  fears over the US rating which undermined the dollar.

Within the FOMC minutes, the Fed forecast a deeper GDP contraction for 2009 and also lowered the 2010 growth forecast. The Fed members also discussed increasing the quantitative easing programme at the meeting which was another factor in undermining sentiment towards the US currency.

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The Euro will continue to gain some support if there is a sustained improvement in risk appetite. There will also be further optimism that the Euro-zone economy is stabilising following the significant improvement in confidence surveys. The improvement in confidence could still prove to be brittle, especially if fears over the Eastern Europe and Baltic states increase again. There may also be some reservations over Euro gains from Euro-zone central banks and finance officials which would limit currency support.

The Euro was generally hesitant on the crosses over the week and lost ground against Sterling, but wider dollar weakness was crucial in allowing a rally to highs above 1.39 against the US currency.

The German ZEW index rose to 31.1 in May from 13.0 the previous month which was the seventh consecutive increase. The ZEW institute was generally optimistic that the economy was recovering. The ZEW still warned that the recovery could be weak and that its pattern was uncertain which created some caution.

The Euro-zone PMI indices continued to improve with most country indicators at an eight-month high with the manufacturing index rising to 40.5 from 36.8 previously. The rise helped reinforce expectations of a measured Euro-zone recovery.

The Portuguese Finance Minister stated that a firm Euro was not a problem which lessened immediate speculation of verbal intervention to weaken the currency,

Yen:  

The yen has proved to be broadly resilient in the face of an underlying improvement in risk appetite and there has also been evidence of increased option-related demand for the Japanese currency. The yen will still tend to lose some ground if there is a sustained improvement in confidence towards the global economy. Despite recent denials, there will also be the risk of Bank of Japan verbal intervention if there are sustained gains for the Japanese currency. In this environment, the yen will struggle to secure more than limited gains.

The yen proved generally resilient during the week and was able to limit losses against the main European crosses. With the dollar under wider pressure, the Japanese currency strengthened to highs just beyond 94 against the dollar.

The first-quarter Japanese GDP data was marginally stronger than expected, but there was still quarterly contraction of 4.0% as investment and exports both continued to fall sharply. There was still some optimism that conditions were starting to stabilise.

The monthly Reuters Tankan index strengthened to -69 in May from -76 the previous month which continues to suggest that the economy is staging a fragile recovery, although the reading was still extremely weak. The Bank of Japan held interest rates at 0.10% and raised its outlook for the economy.
There were reports that Moody’s would downgrade its rating on Japanese bonds. The agency announced a unified rating of AA2 with the domestic rating raised while the rating adjusted lower and the yen initially recovered following the announcement.

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The evidence continues to suggest that the economy is stabilising with an improvement in the manufacturing sector. There will also be hopes for a recovery in the housing sector, although optimism could quickly flounder given the underlying debt vulnerability and very high debt levels. Following the credit-rating warning, the UK currency will also remain vulnerable on debt fears. Sterling moves will still be correlated strongly with degrees of risk appetite and selling pressure will be contained if risk confidence remains firmer. 

A key feature was Sterling buying support on dips and there were significant gains to 2009 highs near 1.59 against the dollar despite sharp selling pressure at times. The UK currency also secured net gains against the Euro even with a sharp retreat from a peak near the 0.87 level.

The CPI inflation rate fell to 2.3% in April from 2.9% with a -1.2% rate for the RPI as the sharp cuts in interest rates put downward pressure on housing costs. The inflation data was slightly below expectations, although the impact was limited.

The UK corporate earnings data provided some degree of relief while there was also optimism that the government would be in a position to partially sell-off its holdings in the banking sector which helped underpin sentiment.

The Bank of England minutes recorded a 9-0 vote to keep interest rates on hold at 0.50% and to increase the quantitative easing programme by a further GBP50bn. There was a debate as to whether there should be an even more aggressive programme of bond buying which unsettled Sterling to some extent.
The latest CBI industrial survey recorded a further very weak reading for the orders component at -56 from -57 the previous month. The output reading was more positive which maintained hopes that the sector is stabilising.

The UK retail sales figures were stronger than expected with a 0.9% monthly increase for April while the increase for the previous month was revised up to 1.1%.

The impact was overshadowed by the Standard & Poor's announcement that the UK credit rating was being put on negative watch due to budget and debt fears. The AAA rating was maintained for now which will helped lessen the impact while other agencies did not suggest that they were considering further action. The underlying budget data also remained weak with a GBP8.5bn borrowing requirement for April following a GBP18.2bn shortfall previously which reinforced market fears over the debt situation.

Swiss franc

The Swiss economy is likely to stage a weak recovery, but the economy will find it difficult to make strong headway. The global debt fears could trigger some defensive support for the Swiss currency. The National Bank will remain very sensitive to franc strength, especially if the currency extends gains against the dollar as well as the Euro. Overall, there is likely to be opposition to currency gains which will limit the potential for franc appreciation. 

The Swiss currency was unable to make a serious challenge on levels near 1.50 against the Euro during the week and it weakened towards 1.5150 later in the week. The dollar initially held support close to 1.10 against the franc, but weakened to lows near 1.09 after the US currency suffered widespread losses.

The Swiss ZEW business confidence index strengthened to -3.9 in April from -27.7 the previous month which was a two-year high for the index.

Markets remained extremely sensitive to the issue of potential intervention after the reported franc selling seen last Friday.

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The Australian dollar maintained a firm tone over the week and strengthened to fresh 2009 highs with a peak just above the 0.78 level against the US currency.

The currency took advantage of US dollar vulnerability and an overall improvement in risk appetite while gains in commodity prices also offered some support. A Wall Street retreat triggered some caution later in the week and it under-performed the Euro

The comments from Reserve Bank Governor Stevens were cautious, although he was hopeful that there would be a recovery in the global economy by the end of the year and he also stated that interest rates were at a low level. 

The Australian currency should be able to maintain a robust tone in the short-term, although it will be difficult to extend gains much above current levels.

Canadian dollar:

The Canadian dollar maintained a strong tone during the week and strengthened to 2009 highs against the US currency near 1.13. There was significant support after it managed to break through important US dollar support levels around 1.1460.

Firmer oil prices and a general improvement in risk appetite were important in triggering increased demand for the currency. The domestic data failed to have a significant effect with a low headline inflation rate offset by a firmer figure for the underlying rate and global factors remained the dominant influence.

The Canadian currency will continue to benefit from US dollar vulnerability, although it may be difficult o extend the gains much further.

Indian rupee:

The rupee strengthened very sharply at the beginning of the week with gains through the 48 level against the dollar. The currency gained strong support from the unexpected Congress Party victory in the general election

There was optimism that capital inflows would strengthen further and there have already been inflows of around US$3.0bn for this month. The rupee also benefitted from the general improvement in risk appetite and a weaker US currency with the potential benefit offset to some extent by higher oil prices. The Indian currency tested levels beyond 47 before a slight corrective retreat.

The rupee will continue to gain support from optimism over capital inflows. A generally weak US currency would also provide support, although it may be difficult to extend gains much further in the very short-term.  

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The Hong Kong dollar edged slightly away from the 7.75 strongest limit against the dollar with some evidence of increased corporate US currency demand.

A weak US dollar and optimism over capital inflows limited any losses for the currency as underlying risk appetite remained firmer. HKMA chief Yam stated that there was no reason to change the dollar peg against the US currency.

Given the improvement in confidence surrounding the regional economy, the Hong Kong dollar is unlikely to weaken sharply at this stage.   

Chinese yuan:

The yuan edged slightly stronger against the US currency and pushed to 8-month highs in the NDF market although moves were limited in the spot market with the yuan near 6.8240. Volatility also fell to a 13-month low which suggested that markets were not expecting major moves in the short-term..

There was further cautious optimism over the Chinese economy, although the focus tended to return back to the US economy over the week. Speculation over reserve diversification provided some underlying support.

The yuan will continue to be influenced strongly by degrees of optimism over the global economy. Given the weaker US dollar tone, the yuan should maintain a firm underlying tone even if gains are limited.