Weekly Forex Currency Review 22-10-2010

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Official foreign-exchange policies will continue to be a very important focus in the short-term, especially with currency issues an important area of focus for global policy-makers. There will be doubts whether the major governments will be able to secure more than vague agreements to curb excessive exchange-rate movements. Market volatility is liable to remain higher with the risk of a sudden reversal in capital flows.              

Key events for the forthcoming week

Dollar:

Over the past week, there has been little in the way of evidence to change the expectations of subdued US economic growth and Federal Reserve policy developments will remain a very important market focus.  There will strong expectations that the Fed will announce a second round of quantitative easing which would reinforce generally negative sentiment surrounding the US currency.  G7 officials will look to stabilise currency markets while the other key economies will not want their own currencies to appreciate and negative dollar trends have been priced in. These factors should provide some dollar support, but strong demand is unlikely unless global credit conditions deteriorate.  
The dollar secured some relief over the week and rebounded from 10-month lows against major currencies, but there was selling pressure on rallies as underlying confidence in the economy and currency remained weak.
The US housing-sector data was slightly stronger than expected with an NAHB gain to 16 for October from 13 the previous month. In contrast, the industrial data was disappointing with a 0.2% monthly decline for September. Jobless claims declined to 452,000 in the latest week from 475,000 previously while there was a recovery in the Philadelphia Fed index to 1.0 from -0.7 previously.

The housing starts data was slightly stronger than expected with an annual rate of 0.61mn for September, unchanged from the upwardly-revised August data. Any positive impact on confidence towards the US economy was offset by a decline in permits to a 0.54mn annual rate, the lowest figure since March.

With permits the more forward - looking indicator, there were fresh doubts over the economy. Regional Fed President Lockhart reiterated that he was leaning towards pushing for further quantitative easing and Governor Dudley was also very cautious over the economic outlook.

There were comments from the more hawkish Fed members that additional quantitative easing would be ineffective, but markets assumed that there will be further measures in November. There was also speculation over a much bigger than expected US$500bn Fed package following the release of a report from an influential advisory group, reportedly with sources close to the central bank.

The capital-account data recorded long-term capital inflows of US$128.7bn for August from US$61.2bn previously. Although the overall figure was capital inflows was more modest, the strength of long-term flows provided some degree of relief.
US Treasury Secretary Geithner stated that currencies were now in equilibrium and that no further weakness in the dollar was justified.

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The latest PMI data from the Euro-zone continues to suggest that there will be subdued growth as domestic demand remains weak. There will also be a negative impact from regional fiscal tightening. Although the ECB will look to withdraw excess liquidity, the bank will find it very difficult to sanction any significant policy tightening. There are also still very important structural weaknesses which will maintain underlying Euro vulnerability and confidence could deteriorate rapidly.  

The Euro was vulnerable to profit taking on the dollar during the week with the first reversal in six weeks against the US currency. There was still firm buying support on dips as markets had little confidence in the major alternatives.

The Euro-zone economic data did not have a major impact with a firmer than expected reading for the manufacturing PMI index offset by a weaker services sector reading. There was a small decline in the German ZEW business confidence reading.

There will be fears over a further slowdown in the domestic economy as fiscal tightening takes effect and this will increase pressure for Euro gains to be resisted as European economies will be looking to maintain export-sector growth.

ECB member Noyer stated that there was no problem with the Euro’s current valuation which dampened expectations of aggressive action to curb the Euro’s value.

Yen: 

The Japanese fundamental outlook will remain very fragile which will limit buying support for the yen.  Capital outflows from Japan are still likely to be limited which will curb any selling pressure on the Japanese currency. The domestic and international currency policies will remain a very important focus in the short-term. There are likely to be G7 attempts to stabilise currencies and there will also be further Japanese opposition to yen strength. In this environment, intervention will remain an important policy option which will limit any scope for yen gains.  

The dollar was subjected to renewed pressure at times during the week and retreated to a fresh 15-year low against the yen with a drop below the 81 level.

There was some reluctance to push the US currency weaker in case it triggered fresh Bank of Japan intervention and the dollar briefly spiked to a high around 81.80 in Asia on Thursday with some rumours of central-bank moves. The dollar was unable to sustain the advance and weakened back to the 81 area on weak yield support.

There was also reservations over aggressive policy moves ahead of the G20 meetings at the end of this week with investors wary that there could be efforts to contain currencies within pre-planned ranges and deter speculative capital flows.  

The Chinese economic data was broadly close to expectations with a GDP figure of 9.6% and risk conditions were broadly stable following the batch of releases with no major impact on the yen.

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There will be expectations of weaker UK growth as the fiscal tightening takes effect and there will also be fears that weak credit demand and supply will have an adverse impact on the growth potential. There will be persistent expectations that the Bank of England will move towards further quantitative easing which will tend to undermine Sterling sentiment, especially with the government pushing for additional monetary support. There will still be important protection from a lack of confidence in the major currency alternatives which should limit selling pressure on Sterling.

Expectations that the Bank of England would move close to further easing over the next few meetings pushed Sterling down to lows near 1.5650 against the dollar while it also weakened to six-month lows near 0.89 against the Euro. The UK retail sales data was weaker than expected with a 0.2% decline for September following a revised 0.7% fall the previous month. Although industry surveys have tended to suggest a more optimistic outlook, underlying confidence surrounding the economy will remain weak.

The latest Bank of England minutes recorded a 7-2 vote for keeping interest rates and quantitative easing unchanged in October. Sentance again voted for an increase in interest rates of 0.25% while Posen voted for an increase in the amount of quantitative easing to GBP250bn from GBP200bn. Former Bank of England MPC member Blanchflower warned that there was a high risk of a double-dip recession.

The government spending cuts were broadly in line with expectations and there was a relatively favourable market reaction with relief that the deficit is being tackled, especially as the latest deficit data registered a GBP15.7bn borrowing requirement for September which was the highest figure on record for that month.

In this environment, there will be further expectations of additional quantitative easing by the Bank of England. Medium-term bond yields remain at extremely low levels which will tend to undermine capital flows into the UK. Any evidence of a much sharper slowdown in the economy would also tend to unsettle investor confidence in the government’s fiscal policies.

Swiss franc:

The Swiss franc will continue to gain defensive support from expectations that other major central banks will pursue further quantitative easing and also directly or indirectly promote a weaker currency to help boost trade conditions. From a shorter-term perspective, there will still be the possibility of National Bank action to slow any rapid franc advance, especially if deflationary pressure starts to return within the economy. Overall, the franc should be able to resist heavy selling given the external currency vulnerabilities.

The Euro proved to be more resilient against the franc during the week with a recovery back to the 1.35 area while the dollar found support below 0.95 and advanced to a highs above 0.97.

Developments surrounding quantitative easing within the major economies will remain an important focus. As well as expectations of further Federal Reserve action, there was further speculation that the ECB will need to be more aggressive than it wants to be in order to combat weakness in the financial sector. In this environment, the franc was able to resist heavy selling pressure during the week.

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The Australian dollar was unable to make a further challenge on parity against the US dollar during the week and retreated to lows below 0.97, although there was robust buying support on dips as underlying confidence remained firm. Yield spreads also remained firmly in the Australian dollar’s favour.

The Reserve Bank of Australia minutes were slightly tougher than expected with comments that the decision between holding rates and increasing rates were finely balanced which increased speculation that the bank could decide on a rate increase at the November meeting.

Markets will continue to have the parity level against the US dollar in focus, although a further period of correction and consolidation is realistic in the near term.

Canadian dollar:

The Canadian dollar was unable to sustain a move through parity and weakened to lows beyond 1.03 as the US currency secured a rapid reversal. There was further choppy trading during the week as it consolidated around 1.0250.

Risk conditions were slightly less favourable during the week while there was a decline in commodity prices in a correction from recent gains. The Bank of Canada left interest rates on hold at 1.00% and was generally cautious over the economic outlook given weaknesses in the other major economies.

The fundamentals suggest that the Canadian dollar should be able to resist heavy selling pressure while it will remain difficult to sustain advances beyond parity.

Indian rupee:

The rupee maintained a firm tone during the week, but was unable to extend the gains seen over the past few weeks with resistance seen close to 44 against the US dollar.

A limited recovery in the US currency helped stifle rupee gains while there were further doubts over the longer-term competitive situation.

The capital account trends remained extremely important and there were fears that there would be significant capital outflows from India once the current round of IPOs were completed as excess funds were returned to prospective investors.  

The rupee should remain broadly firm given US vulnerability and expectations of emerging-market inflows, but competitiveness issues are likely to curb gains. 

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The Hong Kong dollar continued to hit strong resistance beyond 7.7550 against the US dollar during the week and weakened to test support near 7.7650 with some measure of dollar relief curbing immediate demand for the Hong Kong currency.

From a longer-term perspective, there was increased evidence of capital inflows into the Hong Kong currency on speculation that a persistently weak US dollar and low interest rates could eventually trigger a Hong Kong dollar revaluation.

The Hong Kong dollar should maintain a generally firm tone in the short-term, especially with speculation over a medium-term breaking of the peg.

Chinese yuan:

The yuan strengthened at times during the week, but was unable to make strong headway and consolidated slightly weaker near 6.67 against the US dollar. There were brief gains following an incorrect central bank fixing which soon faded.

Domestically, the Chinese central bank sanctioned an unexpected 0.25% increase in interest rates with the lending rate at 5.56% and the widening yield gap increased speculation that speculative capital flows could increase which would tend to intensify underlying pressure for a currency revaluation.

The economic data was broadly in line with expectations with third-quarter GDP increase of 9.6% while there was a 3.6% consumer inflation rate. There was further international pressure for a stronger yuan, although the rhetoric was slightly calmer.

There will be strong expectations of further yuan appreciation in the medium term as capital inflows are liable to increase. The central bank is likely to resist any rapid pace of currency appreciation.

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