Weekly Forex Currency Review 27-05-2011

Overall strategy: Conditions within the US and global economy will be watched very closely in the short-term. There will be reduced speculation over any near-term tightening by the US Federal Reserve, but there will also be major fears surrounding the Euro-zone and doubts surrounding the global economy are also liable to increase. The dollar can still gain significant protection at times, but will find it difficult to gain strong support given underlying fundamental vulnerability.  

 Key events for the forthcoming week 

 Market analysis

Dollar:

The recent economic data releases have remained generally lacklustre with underlying evidence of a significant deterioration in conditions over the past few weeks. This slowdown will continue to have an important impact on interest rate expectations. Although markets are still expecting the Federal Reserve to end quantitative easing at the end of next month, expectations are for policy to be left on hold for a further extended period rather than sanctioning any tightening. The dollar will, therefore, be unable to gain support on yield grounds and there will be further unease over the debt fundamentals. The dollar should still gain protection from a lack of confidence in the other key currencies and a more defensive attitude toward risk.

The dollar strengthened at times during the week, but failed to hold the gains as it was weighed down by a lack of fundamental support and was unable to sustain gains through 1.40 against the Euro.

The US economic data was weaker than expected as the second estimate of first-quarter GDP was unchanged at 1.8% compared with expectations of a rise to above 2.0%. There was a dip in corporate profits which will increase unease over the economic outlook, especially with consumer spending sapped by rising energy costs. The jobless claims data also weaker than expected with an increase to 424,000 in the latest week from a revised 414,000 previously. In response, there was a further decline in US Treasury yields with benchmark yields at just above 3.05%.

The US new home sales data was stronger than expected at 323,000 for April from a revised 301,000 previously while there was a decline in the Richmond Fed manufacturing index. Regional Fed President Bullard stated that the Fed was likely to remain in neutral for some time following the end of quantitative easing in June.

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The Euro-zone structural difficulties will remain an extremely important short-term focus as sovereign-debt risks intensify. Greece will need further substantial fiscal transfers to be able to survive within the Euro and if this is politically unacceptable, then there will need to be a radical change which would trigger initial Euro weakness. There will also be an important contagion risk with the threat of non-peripheral members also coming under pressure.  The ECB will find it difficult to sanction further interest rate increases in this environment which will make it difficult for the Euro to recover strongly given the medium-term valuations.

Overall confidence in the Euro area remained very fragile in the short-term and there was also weaker than expected economic data as the PMI manufacturing index dipped to a 7-month low, although the services data was more encouraging. There was further expectations of Asian central bank reserve diversification which helped the currency rebound from lows.

Following Standard & Poor’s decision to put Italy’s credit rating on negative watch, there was a similar move on Belgium’s rating by fellow agency Fitch. There has been no government in Belgium for 11 months which has increased fears over the sustainability of debt servicing. Italy announced that budget cuts would be brought forward to help boost market confidence.

The ECB remains strongly opposed to any form of restructuring, especially as it could technically make the central bank insolvent given the amount of Greek collateral that it is holding. There has been further political opposition to austerity measures within Greece, while markets remain convinced that some form of restructuring or partial default remains inevitable.

The Euro fell sharply after Euro-group head Juncker stated that Greece may not receive the next scheduled EUR12bn loan tranche due to the failure to meet budget targets.  Given Greece’s short-term funding needs, such action would push the country to default. The Euro countries will continue to push Greece hard in order to secure concessions, but there will also be strong internal opposition to fresh measures. 

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Overall confidence in the economy and fundamentals will remain extremely fragile as economic vulnerability continues following the earthquake damage. From a longer-term perspective, there will be major fears over the debt situation, especially with the savings rate set to decline. These factors will tend to undermine the yen, although there will also be an increasing impact from capital repatriation as Japanese funds will need to boost domestic capital. The yen will also gain at times from a deterioration in risk appetite, although strong gains remain unlikely.

The dollar was unable to make any challenge on resistance levels above 82.20 against the yen and weakened sharply following the US economic data releases later in the week with an immediate low below 81.50. The yen gained support from a further decline in US bond yields and there was also a general deterioration in risk appetite following the Euro-zone developments which also bolstered the Japanese currency.The yen will continue to gain some protection from a lack of confidence in the Euro and dollar, although it will still be difficult to translate this into strong yen gains given the fundamental outlook.

As far as the domestic economic data is concerned, consumer prices rose 0.6% in the year to April under the influence of rising energy costs. The annual decline in retail sales slowed to 4.8% from 8.3% as the immediate earthquake impact faded.

The latest Japanese trade data recorded an April deficit for the first time in over 30 years with a JPY0.46trn shortfall as exports remained under pressure. The latest Bank of Japan minutes stated that there was a discussion over additional support for the economy with one member voting for extra measures.

Sterling:

There will be further expectations of an underlying deterioration in the UK economy as fiscal tightening takes effect and consumer spending remains under pressure.  There is the possibility of a small rise in interest rates, but the overall policy mix will demand low Bank of England interest rates over the next few months. The UK banking sector will also be an important focus and there will be fears over fresh vulnerability, especially if there is any Euro-zone debt restructuring. Sterling will still gain some important near-term protection from a lack of confidence in the Euro and dollar.

Sterling was able to gain ground over the week as a whole as fears over the Euro and US outlooks out-weighed a lack of confidence in the UK economy.

The headline UK government borrowing requirement was higher than expected at GBP7.7bn for April compared with expectations of a GBP5.0bn figure, but the data was distorted by one-off factors and differences in timing of bank-tax receipts. The latest CBI retail sales survey was stronger than expected, although there was general caution over the consumer spending outlook. The GfK consumer confidence reading improved to -21 from -31 previously.

Divisions within the Bank of England were illustrated by comments during the week. Weale stated that an early rise in rates was advisable  to prevent the need for larger rate increases later while Fisher stated that a rate increase now would be the worst thing to do.  Tucker stated that he was concerned over inflation and the comments suggested that he could switch to favour an interest rate increase at the June meeting which would leave the net outcome extremely finely balanced. Fellow member Posen, in contrast, continued to warn that raising interest rates would be the wrong policy option given the tight fiscal policy.

Unease over the banking sector remained a significant factor after Business Secretary Cable warned over further shocks to the system, but weakness elsewhere was important in curbing any Sterling selling pressure.

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International considerations will continue to dominate in the short-term. The Swiss currency will remain the ultimate safe-haven currency, especially with all major alternatives suffering from a serious lack of confidence. Any debt restructuring and further deterioration in the Euro-zone banking sector would also boost the Swiss currency.  There will pressure for National Bank action to curb fresh appreciation and the Swiss banking sector also has important vulnerabilities. The net risks still suggest that heavy franc selling is unlikely in the short-term.

After strong gains early in the week, there were reports that the National Bank intervened to support the Euro and the Swiss currency retreated back to the 1.2460 area in Asia on Tuesday as long positions were scaled back.  The National Bank declined to comment on the intervention rumours, but bank member Jordan did state that the central bank was very worried over the exchange rate.

There was fresh selling pressure on the US economy in the US session following weaker than expected US data and a deterioration in risk appetite. The Euro came under heavy selling pressure against the franc and retreated to fresh record lows below 1.22 in Asia on Friday. This move, allied with a generally weaker US performance, pushed the dollar to lows below 0.8550.

A structural lack of confidence in the dollar and Euro will continue to push funds towards the Swiss franc and increase pressure for National Bank action to weaken the currency with volatility set to remain extremely high. 

Australian dollar:

The Australian dollar hit resistance close to the 1.07 level against the US dollar during the week and dipped to test support below 1.05 as risk appetite deteriorated with a slide in the Euro, but there was a recovery back to the 1.07 area as the US currency failed to sustain its advantage.

There were no major domestic developments with a solid reading for capital spending having some impact. There were reservations over the housing sector following a downgrading of bank credit ratings there was also a rise in housing delinquency rates which curbed support for the Australian currency to some extent.

There will continue to be strong-buying support for the Australian dollar on retreats, but the net trend is liable to be for a further correction weaker against the US dollar.

Canadian dollar:

The Canadian dollar hit resistance close to 0.9650 against the US dollar during the week, but found support close to the 0.98 level as the US currency was unable to secure follow-through buying interest.

There were no major domestic developments during week to influence the currency as risk appetite and commodity markets continued to have an important impact. Risk conditions deteriorated in the middle of the week before a tentative recovery in choppy trading even though ranges were relatively narrow.

The Canadian dollar is liable to drift weaker given that it remains over-valued and there will again be sharper losses if commodity prices decline again.

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The rupee maintained a weaker tone during the week and it weakened to a 3-month low just beyond 45.40 against the US currency, although losses were relatively contained as the dollar also failed to sustain wider gains.

There was month-end dollar demand relating to oil payments which undermined the currency and there was further evidence of overseas selling with some unease over a deterioration in export prospects also having a negative currency impact.

The rupee should be able to avoid heavy losses even though it will be difficult for the currency to make a strong recovery given doubts over capital flows.

Hong Kong dollar:

The Hong Kong dollar had a weaker tone during the week and dipped to test support beyond 7.7850 against the US dollar. There was an outflow of funds following the Glencore IPO which had some negative impact on the local currency and risk conditions were fragile as unease over China’s economy continued.

From a longer-term perspective, the HKMA ordered stress tests on the banking sector given fears over an outflow of funds in the event of any increase in US interest rates. There was further unease surrounding the growth of yuan-denominated bank deposits.

The Hong Kong dollar should be able to resist strong selling pressure, but there will be increased speculation over the peg’s outlook with potentially higher volatility.

Chinese yuan:

The yuan resisted any significant losses during the week and pushed stronger with the central bank setting a new post-float record high just beyond 6.49 against the US dollar. There were further indications that the central bank would allow further gradual yuan appreciation to help curb inflation.

The latest manufacturing PMI index weakened to a 10-month low which reinforced fears over a sharp slowdown in the economy and the risk of rising stresses within the housing sector.

There is still the potential for gradual short-term yuan appreciation, although the central bank will find it increasingly difficult to maintain stability.