Weekly Forex Currency Review 04-03-2011

Central bank responses to higher food and energy costs will continue to be a very important market factor in the short-term. The ECB’s natural response is to tighten policy while the Fed takes a more pro-growth stance.  This has been illustrated clearly this week by the ECB’s warning that interest rates will rise in April while the Fed continues to concentrate on growth. This contrast will tend to provide near-term Euro support, but sentiment is liable to turn frequently given the potential for renewed financial-sector stresses.          

 Key events for the forthcoming week

 Market analysis

Dollar:

The US economic data has remained encouraging, especially in manufacturing, and growth should remain firm in the short-term despite unease over the impact of high oil prices. The Federal Reserve will remain under close scrutiny and there is no evidence as yet that they will consider an early policy shift which will dampen demand for the dollar on yield grounds. Budget fears will also be an important medium-term focus which will certainly have a negative impact at times and there is the persistent threat of reserve diversification. The dollar has found it difficult to gain defensive support on deteriorating risk appetite, but there will be support if there is a sustained move away from emerging markets.

The dollar generally remained on the defensive during the week despite firm data releases and was near 4-month lows with the currency unable to derive safe-haven support. There were also underlying fears over the US budget position, especially with further concerns over the threat of municipal debt defaults.

The US PMI manufacturing index again registered a strong reading as it advanced to the highest level since 2004 at 61.4 for February from 60.8 previously. There was also a strong reading for the employment component.

There was an ADP employment increase of 217,000 for February following a revised 189,000 gain the previous month. The data later in the week received less attention than usual, but maintained a stronger tone as jobless claims fell to 368,000 in the latest week from a revised 388,000 previously. The ISM services-sector index also rose to 59.7 from 59.4 previously.

The Federal Reserve Beige Book reported that the economy was still growing moderately while there was evidence of manufacturers passing on higher costs.

Fed Chairman Bernanke recognised that the economic performance has improved, but he also stated that he wants to see a sustained improvement in the labour market and a self-sustaining recovery before tightening monetary policy. The comments were broadly in line with expectations and reinforced expectations that the Fed would be very slow to tighten policy.

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The ECB decision to effectively pre-announce an April interest rate increase will boost the Euro initially through high yields and the inflation-fighting credentials have been boosted which will underpin credibility. There will be fears over a renewed downturn in the economy and the potential damage will be increased by the fact that peripheral economies will be most vulnerable which will exacerbate debt problems. Political negotiations surrounding the Euro-zone support fund will also be watched very closely as there will certainly be further tensions and market confidence could deteriorate rapidly on renewed sovereign debt fears. The Euro may, therefore, find it difficult to sustain a strong tone.

The Euro maintained a very firm tone during the week, reaching fresh four-month highs above 1.3950 against the dollar and registering significant advances on the main crosses.

The Euro-zone data remained generally encouraging with a sharper than expected decline of 52,000 in German unemployment while there were solid readings for the PMI indices. There were still very important reservations surrounding the peripheral economies as they remain trapped in recession. There will also be fears that higher energy prices will put renewed downward pressure on growth.

There were no surprises from the ECB interest rate decision on Thursday with the main lending rate held at 1.0%. President Trichet’s press conference, however, was significantly more hawkish than expected as references to monetary policy being appropriate were dropped and he also stated that inflation risks had risen with strong vigilance needed. These were very strong hints that a near-term rate increase is likely. To reinforce the point, he stated that an increase could be considered at the April meeting, although he also stated that the bank was not looking at a series of increases.

Overall, the ECB has given a clear signal that rates will be increased in April unless there is some major market dislocation in the meantime and the Euro will gain further yield-related support in the near term. There will, however, also be fears that peripheral economies will suffer further damage and there will also be further political tensions surrounding sovereign debt concerns. The summit of centre-right governments will be watched closely on Friday to assess whether any compromise agreement is a realistic possibility later in March.

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Trends in risk appetite will remain very important and the yen will gain further support when global confidence deteriorates. There will also be yen backing from capital repatriation over the next few weeks ahead of the fiscal year-end. The Japanese currency will remain vulnerable on yield grounds in the short-term as rising US and Euro-zone bond yields undermine capital inflows.  From a medium-term perspective, overall confidence in the Japanese fundamentals is also likely to remain weak as the rising debt burden saps confidence and sustained yen gains will be difficult.

The dollar found support on dips to below 82 against the yen and edged back above 82 later in the week. The US currency gained support as Treasury yields rose strongly and there was also important cross-related selling at the Japanese currency retreated sharply against the Euro.

Yield considerations will remain important in the short-term and there will be further dollar support if there is a better than expected US employment report on Friday. 

Domestically, despite recent signs of better than expected growth data, Bank of Japan Shirakawa continued to warn over the deflation threat which suggests that the bank will maintain a very expansionary monetary policy.

Capital repatriation flows will be watched closely as there is scope for significant flows over the next three weeks before the Japanese fiscal year-end.

Sterling:

There will be further pressure on the Bank of England to increase interest rates on inflation grounds and it is clear that the central bank is very close to an increase. The ECB decision will also increase the potential for an increase at one of the next two meetings. The growth trends will be watched closely and Sterling will be vulnerable to renewed selling if the economy appears to be weakening rapidly. The currency will not gain support if higher inflation is accompanied by a move back towards recession. There will also be unease over the banking sector and Sterling overall will find it difficult to make much headway.

Sterling advanced against the dollar for the week as a whole, but did find it difficult to breakdown resistance above 1.63 and it also retreated to near 0.86 against the Euro.

The PMI manufacturing index maintained a strong tone as it held close to record highs above the 61 level for February while the construction index to 56.5 for February from 53.7 the previous month. In contrast, the CIPS services-sector data which registered a decline to 52.6 for February from 54.5 previously.

The non-manufacturing data will increase unease over potential economic trends in the economy given the dominance of the services sector and this will make it more difficult for the Bank of England to justify a tighter monetary policy in the near term.

In testimony to the Treasury Select Committee, Bank of England MPC members continued to express concerns over inflation, but there was also a high degree of uncertainty over the economic outlook. The consensus appeared to be an acceptance that interest rates would need to rise slightly, but that there was no urgency.

Bean, for example, stated that inflation may be more persistent than expected, but also that there were some warning signs over a slowdown in the economy.  There is likely to be a high degree of uncertainty running into Thursday’s policy announcement.

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The franc will continue to be strongly influenced by trends in risk appetite and there will certainly be support at times when risk conditions deteriorate, especially if there are renewed Euro-zone area fears. There will also be optimism that the economy can deal with the impact of currency strength following the recent favourable growth indicators. High volatility is likely to remain an important factor on major shifts in international sentiment.

The franc pushed to a record high close to 0.92 against the dollar and also tested Euro support close to 1.27. Risk appetite remained the dominant focus and the franc gained renewed support from fears surrounding the Middle East situation, especially with rumours of unrest in  Saudi Arabia. The franc will continue to draw important support from the notable absence of attractive alternatives.

There was a sharp reversal for the Swiss franc on Thursday as the Euro found very strong support following the ECB press conference. The franc weakened to beyond 1.30 from near 1.2850 and the dollar was also able to move back above 0.93.

The National Bank will be very cautious over raising interest rates which will tend to lessen yield support if the ECB raises rates in April and the central bank will certainly not oppose any further currency retreat.

The Euro-zone sovereign-debt issues will still be watched very closely as renewed tensions could lead to fresh demand for the Swiss currency.

Australian dollar:

The Australian dollar found support just below parity against the US dollar during the week and rallied to re-challenge highs near 1.02, but failed to sustain the advance and settled near the middle of its weekly range.

The domestic influences were mixed as a robust trade performance was offset by a sharp decline in building approvals. There were no surprises from the Reserve Bank as interest rates were held at 4.75%.

The currency was unsettled at times by deteriorating risk appetite and there was also a warning from Prime Minister Gillard over the negative impact of a strong currency.

Even if the currency can maintain a firm tone, reservations over domestic and global conditions will make it difficult for the  Australian dollar to reach new peaks.

Canadian dollar:

The Canadian dollar resisted selling pressure against the US currency during the week and pushed to 30-month highs near 0.97 before correcting slightly weaker. The currency was boosted by high energy prices throughout the week and markets also wanted to take an optimistic tone towards growth trends.

The Bank of Canada left interest rates on hold at 1.0% and stated that any further increases would be carefully considered which dampened demand for the currency to some extent. Underlying confidence in the fundamentals held firm.

The Canadian dollar will continue to draw support from the high level of energy prices. It will still be difficult for the currency to advance far from current levels.

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The rupee again proved resilient during the week and challenged two-month highs beyond 45.0 against the US dollar. The rupee was hampered by the high level of oil prices and the deterioration in risk appetite had an important negative impact at times.

The was relief that the domestic and regional equity markets were broadly resilient and there was also support from stronger than expected export data.

Although the currency can prove to be resilient, the rupee will find it difficult to secure strong support, especially as emerging-market sentiment is likely to remain generally fragile over the next few weeks at least.

Hong Kong dollar:

The Hong Kong dollar found support close to 7.7950 against the US dollar and had a firmer tone over the week with a move to highs near 7.7860.

International risk conditions remained important, but a generally fragile US currency helped lessen immediate selling pressure on the local currency. From a medium-term perspective, the authorities stated that a currency peg to the Chinese yuan was not a viable option.

The Hong Kong dollar will be more vulnerable when international risk appetite deteriorates, but heavy pressure should be resisted given the US monetary stance.

Chinese yuan:

The yuan edged advanced during the week as a whole and pushed to a post-float high beyond 6.57, although it was hampered at times by strong dollar demand from importers. The PMI data confirmed a slowdown for the economy, but the immediate currency impact was limited.

The National People’s Congress will be held over the next two weeks which is likely to curb currency moves, but the central bank was happy to set record-high fixes which suggests that they are willing to see the currency advance

The evidence suggests that the central bank will continue to encourage gradual yuan appreciation with market stability also seen as a very important objective.

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