Weekly Forex Currency Review 25-07-2008

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Overall strategy:

Growth and interest rate expectations will continue to be very important for market sentiment in the short-term. The scaling back of US interest rate expectations will remain a negative dollar factor in the near term, but the Euro-zone will be at risk of increased capital outflows.  The G8 response to a renewed surge in commodity prices will need to be watched very closely in the short-term with volatility levels liable to increase.                    

Key events for the forthcoming week

Dollar:

The most recent data releases have suggested that the US economy remains vulnerable and there is the risk of a further deterioration, although the key feature is likely to be major uncertainty as there will still be some optimism over a subdued recovery later in 2008. The Federal Reserve has switched to a slightly more aggressive policy, but is still reluctant to tighten in the near term and yield support will be limited. There is still the scope for investment flows into the US, especially with increased doubts over the global economy. The dollar should be resilient, but will struggle to secure more than limited gains.   

The dollar initially strengthened during the week, but was unable to break key Euro support levels and then weakened steadily with lows beyond 1.5750 while the trade-weighted index also stumbled.

The Federal Reserve left interest rates on hold at 2.0% following the latest FOMC meeting. There was 9-1 vote with Fisher dissenting and calling for a rate increase.

In the statement accompanying the decision, the Fed stated that inflation risks had increased, although it still expected a decline in the rate over the next year. There was less pessimism over growth despite warnings that the labour market was softer while there was on-going weakness in the housing sector.

Consumer confidence weakened further in June to 50.4 from a revised 58.1 the previous month and this was the 5th lowest reading in the history of the survey as expectations remained extremely weak.

Durable goods orders were unchanged for May while jobless claims were unchanged at 384,000, although the underlying trend suggested a small increase. New home sales fell slightly over the month while there was a small increase in existing home sales. House prices continued to fall with the Case-Shiller index recording a 15.6% decline in prices in the year to April.

The net impact was a downgrading of market expectations surrounding potential interest rate increases by the Federal Reserve. Futures markets put the chances of an August rate increase at below 25% compared with over 50% previously.

There were no significant comments on exchange rates from Treasury of Fed officials and the dollar was unsettled late in the week by a sharp decline on Wall Street together with fresh record highs for oil prices abvove US$140 per barrel.

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The ECB will maintain a tough approach on inflation in the short-term which will help underpin the Euro. Internal divisions are still liable to increase, especially with evidence of further deterioration in the economy. In this environment, political stresses are liable to increase which will tend to magnify capital outflows. Overall, the Euro remains structurally vulnerable which will limit gains and any further increase in market tensions would increase speculation that the ECB will not push ahead with the planned July tightening.        
       
The Euro secured a generally firm tone over the week with the tough central bank stance on inflation offsetting the impact of economic unease.

The Euro-zone data remained generally weak and unsettled the Euro at times. The German IFO index weakened to 101.3 in June from 103.5 which was the lowest reading since 2005. The PMI indices for the manufacturing and services sectors both weakened to below the 50.0 level for June with the services sector at a 5-year low. There was notable weakness in the French PMI data for the month.

There were some areas of optimism with a rise in French business confidence while Euro-zone industrial orders also rose, but the consumer mood remained downbeat.

The ECB maintained a broadly similar approach to policy in its latest comments. President Trichet stated that inflation risks had increased with a particular concern over wage developments. There were, however, further comments suggesting that only a small rise in rates was being considered and no series of increases.

Government officials in the region were less confident over the situation with warnings that an interest rate increase would be damaging for the economy.

Yen:  

The domestic data remains uninspiring which will keep the Japanese currency on the defensive, especially with a lack of yield support as the Bank of Japan stays on hold. There will be a further temptation to push funds into high-yield overseas assets which will tend to weaken the yen. Increased doubts over the global economy will, however, pose important risks to carry trades and there will be important defensive demand for the yen at times, especially if equity markets continue to slide. 
                    
The Japanese currency found further support weaker than the 108.30 level against the dollar and strengthened back to beyond 107.0 on Thursday. The yen weakened to all-time lows against the Euro before finding some respite.

The domestic data was mixed over the week as growth and inflation fears persisted. There was a solid 2.9% rebound in industrial production for May, but the household spending data was weak with a 3.2% annual decline.

Underlying consumer prices rose 1.5% in the year to May and this was the highest reading for 10 years as fuel prices rose sharply over the month.

The Bank of Japan remained generally cautious over the economic prospects, warning that the domestic and global economy faced testing conditions, while there was no suggestion of an imminent increase in interest rates.

The capital account data suggested there were substantial outflows from Japan. There was also speculation over an increase in flows into investment trusts which placed funds into offshore high-yield bonds, supported by summer bonus payments.

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The latest housing data will reinforce expectations of a sharp slowdown in the economy and the threat of recession. The growth considerations will certainly complicate the Bank of England's options in the short-term, but the possibility of a rate increase to control inflation will offer some Sterling support. A lack of confidence in the US and Euro-zone may also offer some protection on relative grounds even if the domestic prospects are poor. The UK currency is still unlikely to make strong headway in the short-term. 
 
The UK currency weakened marginally against the Euro over the week, although ranges were generally narrow. Sterling strengthened to 1-month highs against the dollar above the 1.9850 level before edging lower.

The latest BBA data recorded a further decline in mortgage approvals in May to the lowest level since the survey started in 1997. The latest CBI retail sales survey was slightly more optimistic that the previous month, although there was still a net balance reporting lower sales for the month.

In testimony to the Treasury, the Bank of England MPC member continued to warn over the inflation outlook with the potential for the rate to move above the 4.0% level this year. MPC members stated that the bank would do what was required to get inflation back to the 2.0% level, but that it would not aim to bring it down too fast. Wage trends would be a key element in determining the bank's policy.

The net effect was a slight downgrading of interest rate expectations over the next few months, although the impact was relatively limited given the global stresses.

Swiss franc:

The Swiss currency will gain some support on defensive grounds, especially  if there is a sustained deterioration in global credit conditions and sharp declines in stock markets. There will be concerns over the domestic economy, especially with speculation that the banking sector will remain under stress which will have a wider negative impact. Overall, the Swiss currency will still find it difficult to secure strong gains given the domestic doubts.    
 
The dollar was unable to break above the 1.05 level against the Swiss franc during the week and dipped sharply to lows near 1.02 over the second half. The franc also found support close to 1.6250 against the Euro.

The Swiss currency gained support late in the week from a sharp downward move in stock markets and a renewed increase in global credit-related stresses.

There were concerns over the domestic economy with fears that further stresses in the banking sector would undermine the Swiss financial sector. There was some speculation over a bid approach for banking group UBS which provided brief support to the Swiss currency. The latest consumption index weakened again in May, although it was still at an historically relatively firm level.

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The Australian dollar retained a generally firm tone over the week as the US currency was subjected to downward pressure. The currency pushed to highs just above the 0.96 level against the US dollar before hitting resistance.

Commodity prices were mixed, but gold prices firmed very sharply late in the week which helped support the Australian currency. Higher iron ore prices were also agreed in the latest contracts which boosted confidence in future export earnings.

Speculation over a domestic interest rate faded, but the potential currency impact was offset by a decline in global yield expectations.

Overall, despite continuing yield support and commodity optimism, the Australian dollar will struggle to secure more than limited further gains against the US currency. 

Canadian dollar:

The Canadian dollar secured small net gains over the week and tested levels below the 1.01 level against the US dollar, but was struggling to make strong headway as conviction over moves was lacking.

There were no significant domestic developments with markets still expecting that the Bank of Canada would leave interest rates on hold in the short-term.

A surge in metals and energy prices over the second half of the week provided some degree of support o the Canadian dollar, but this was offset by an erosion of risk appetite as stock market prices were subjected to downward pressure.

Overall, the Canadian currency is likely to remain blocked on any rallies towards parity against the US dollar with energy prices triggering significant volatility.

Indian rupee:

The rupee found support during much of the week and pushed to a 3-week high against the US dollar on Thursday at around 42.65. The currency was underpinned initially by a further 0.50% increase in the Reserve Bank's key interest rate to control inflation, the second increase during June.

The rupee gained some temporary respite as oil prices weakened and the local stock market attempted to rally. Market conditions were much less favourable late in the week. A combination of weaker equity markets and a surge in oil prices pushed the rupee back towards the 43.0 level on Friday.

Overall, the Indian currency is unlikely to make much headway in the short-term given fears over capital outflows, although there is scope for near-term support close to 43.0 with some central bank support close to this level.

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The Hong Kong currency was able to find further support weaker than the 7.81 level against the US dollar during the week and strengthened to around 7.8025 on Friday.

The HKMA left interest rates on hold following the Federal Reserve decision to leave the Fed funds rate on hold at 2.00%.

There was a decline in US yields over the week which helped stem selling pressure on the Hong Kong dollar. The currency was still unsettled by concerns over the stock market during the week as regional markets dipped sharply.

Overall, the Hong Kong dollar should again be able to resist significant losses against the US currency as arbitrage activity will dip on any move towards the 7.81 level. 

Chinese yuan:

The yuan continued to strengthen during the week with another post-float high against the US currency at near 6.86 before some stabilisation on Friday. The moves were restrained given underlying dollar weakness and futures markets were not signalling expectations of faster appreciation.

The yuan gained support from expectations of capital inflows surrounding the Olympics while there underlying yields moved in the yuan's favour as US yields declined. There were further international calls for the currency to strengthen with IMF head Strauss-Kahn stating that the yuan was substantially under-valued.

Overall yuan volatility is liable to remain higher over the next few weeks. The net flows still suggest that net appreciation is realistic, although the central bank may look to encourage some retracement in the near term.   

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