Weekly Forex Currency Review 05-09-2008

Overall strategy:

Markets will continue to focus on global economic conditions. There has been an important shift in market sentiment with a further sharp decline in carry trades as confidence in high-yield currencies has weakened. This position unwinding could continue in the near term and this would also tend to support the dollar, but the US currency will struggle to extend gains given that US fears are liable to increase again.

Key events for the forthcoming week

Dollar:

The US economic data has remained relatively resilient over the past few weeks. There is, however, little evidence that conditions are improving significantly and there is still an important risk of renewed deterioration in conditions, especially given the pressures on consumer spending as the impact of tax rebates fades. The Federal Reserve is more likely to hold interest rates steady given the decline in oil prices which would reinforce the lack of yield support. The US currency should still gain some important support from a reduction in net outflows and the lack of attractive alternatives which will limit renewed selling pressure.

The dollar has retained a strong tone over the week with the currency strengthening to fresh 11-month highs on a trade-weighted basis. It also strengthened to 2008 highs against the Euro with a peak close to 1.42 on Friday.

The US currency gained support from a sharp reduction in carry trades and a net shift of capital flows into the US currency as fears over the trends in other major economies and emerging markets continued to increase. The net decline in commodity prices was also a positive net dollar factor as positions were reversed.

As far as the economic data is concerned, the PMI index for the manufacturing index was little changed at 49.9 from 50.0 the previous month while the prices index was lower. The services-sector index rose slightly for the month to 50.6 from 49.5, but there was weakness in the employment component while prices rose less strongly.

The industrial data retained a firm tone with factory orders rising 1.3% for July, confirming the more favourable durable goods report.

In contrast, the labour-market data remained less favourable with initial jobless claims rising to 444,000 in the latest week from a revised 429,000 the previous month while continuing claims also continued to rise strongly. The latest ADP employment survey also recorded a 33,000 decline in private-sector employment for August.

The Fed's Beige Book reported that the economy was generally weak with a retrenchment in consumer spending while the labour market was soft. Overall pricing pressures were still important, but wage increases appeared under control. An upward revision to productivity and lower unit labour costs eased inflation fears slightly.

There was little overall move in interest rate spreads, but expectations of an interest rate increase this year continued to fade slightly.

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Sentiment surrounding the Euro-zone will remain weak in the short-term with further expectations that the economy will slide towards recessionary conditions. The drop in commodity prices will also maintain pressure for the ECB to take a less aggressive stance on interest rates within the next few months. Nevertheless, the ECB will look to maintain a tough stance to curb inflation expectations. The capital account is liable to remain generally weaker, but there is scope for some re-assessment of prospects given the shift in confidence that has taken place.              
       
The Euro looked to stage corrective rallies, but quickly encountered selling pressure and weakened sharply on the major crosses, especially against the yen with a slide to 13-month lows near the 150.0 level.

The Euro-zone economic data remained weak and provided no support to the Euro. Retail sales data continued to fall with a further 0.4% decline for July after a revised 0.9% decline the previous month. The revised PMI data for August was little changed, although the services-sector data was revised up to 48.5 from 48.2.

Germany remained an important focus and there was a further 1.7% decline in factory orders after a 2.6% decline the previous month. This was the eighth successive monthly decline for orders which increased economic fears.

The ECB left interest rates at 4.25% at the council meeting. In the press conference following the decision, Chairman Trichet repeated that the growth risks were skewed to the downside. The central bank head also warned over inflation with a statement that inflation would stay above target for a prolonged period. There was a particular focus on wage pressures and the need to avoid secondary inflationary effects.

Yen:  

The domestic condition will remain difficult in the short-term, but it is still the case that international considerations will tend to dominate yen trends. In the near term, there is still the threat of a liquidation of carry trades which would tend to support the Japanese currency. These pressures could also intensify if there is substantial net capital repatriation by Japanese funds. There will still be interest in selling the Japanese currency on any significant rallies given the pressure to boost yields.  
                    
The Japanese currency resisted selling pressure and gained strongly over the second half of the week. The yen advanced to highs around 105.50 against the dollar and also pushed sharply stronger against the Euro with a peak stronger than 151.

Trends in commodity prices and carry trades remained very important for the Japanese currency over the week with further liquidation of positions evident. This pressure accelerated as Wall Street was subjected to heavy selling pressure on Thursday with some evidence of position capitulation.

Prime Minister Fukuda resigned over the inability to push reform legislation through parliament, but there was little market impact as financial conditions dominated.

Bank of Japan Shirakawa also remained cautious over the Japanese economic outlook, but this failed to have a major effect as they were similar to previous comments.

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Recession fears will persist in the short-term as confidence remains at extremely weak level, especially with major stresses in the housing sector. The economy will certainly remain very weak, but the latest data releases suggest that there is scope for a slightly less pessimistic assessment of conditions. The UK currency will still be subjected to further selling pressure if there is a Bank of England interest rate cut and it will also be difficult to reverse underlying negative sentiment which will limit the scope for corrective rallies.

Sterling remained under pressure during the week with the trade-weighted index falling for 12 consecutive days before staging a weak correction. The UK currency dipped to lows below 1.76 against the dollar while it found support close to 0.8180 against the Euro in choppy trading conditions.

The UK currency was hurt badly by the comments from Chancellor Darling who warned that the economic conditions could be the worst for 60 years. Recession fears were reinforced while the OECD was also very cautious over the UK prospects.

The PMI data was slightly better than expected for August. The manufacturing sector index rose to 45.9 from 44.1 previously while the services-sector index recovered to 49.2 from 47.4, although they remained below the 50.0 threshold for expansion.

The government announced a package of measure to support the housing sector with a reduction in house-purchase tax for the next 12 months, but overall confidence in the housing sector remained very low. Mortgage approvals dipped to record lows of 35,000 in July as credit conditions remained tight while bank lending was subdued.

The Bank of England left interest rates on hold at 5.00% following the latest policy meeting. There was no statement or vote split by the bank following the meeting.

Swiss franc:

There will be further expectations of a slowdown in the Swiss economy, with the latest data continuing to suggest an on-going deterioration. The most likely outcome is that the National Bank will hold interest rates steady at the September meeting, but there is likely to be some speculation over a rate cut at the December meeting. The Swiss currency will gain some support on defensive grounds, especially if there are serious stresses in Eastern European currencies.     

The dollar retained a firm tone against the franc, but hit selling pressure above 1.1150 against the Swiss currency. The franc gained support on the crosses as risk aversion increased and advanced strongly against the Euro with highs near 1.58.

The Swiss PMI index weakened to 52.5 from 54.1 the previous month while the KOF index also dipped to 0.68 for August from a revised 0.85 the previous month. The data reinforced market expectation that the economy was slowing sharply.

Consumer prices fell 0.3% in August with the annual rate moving back to below the 3.0% level at 2.9%. National Bank member Jordan stated that the economy would slow significantly over the second half of 2008 while inflation should also fall back to below the 2.0% level by early 2009.

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The Australian dollar remained under selling pressure for much of the week with a retreat to 13-month lows against the US dollar with a slide to near 0.81 on Thursday.

The Reserve Bank cut interest rates by 0.25% to 7.00% following the latest meeting which was in line with market expectations. The bank was still cautious over inflation prospects and did not suggest that a rapid to cut rates was likely. The economic data remained generally weak with the PMI index for the services sector weakening to below the 40.0 level while there was a further decline in building approvals and generally weak construction surveys.

The Australian currency was still influenced strongly by degrees of risk aversion in the markets and the currency was subjected to renewed selling pressure as Wall Street came under heavy selling pressure and commodity prices came under pressure.

There is scope for a corrective Australian dollar rally in the near term after heavy losses, although gains will quickly attract selling pressure as fears over slower domestic and international growth will tend to persist.

Canadian dollar:

Canadian dollar volatility increased sharply over the week. The US currency advanced to highs near 1.0770 ahead of the interest rate decision before weakening sharply to below 1.06 with renewed gains later in the week and a move to near 1.07.

The Bank of Canada left interest rates on hold at 3.00% following the latest policy meeting. The bank took a generally cautious approach with comments that interest rates remained appropriately accommodative at current levels.

The trends in commodity price were important and were a net negative influence on the Canadian currency as oil prices weakened.

Volatility levels are liable to remain higher in the short-term. The US currency should remain firm, but will struggle to extend gains much beyond current levels.

Indian rupee:

The rupee managed to show some resilience, but was unable to make much headway and was trapped weaker than the 44.0 level against the US dollar with lows around 44.60 on Friday. The rupee was supported at lower levels by exporter selling.

There were further underlying fears over capital account trends with confidence in the regional economy weakening. There were also some concerns over the sharp increase in foreign debt seen over the past few months.

The rupee gained some support from exporter dollar selling while there was also evidence of the Reserve Bank intervening to stabilise markets.

Confidence in the economy and region is liable to remain very fragile as growth fears persist. In this environment the rupee is liable to remain on the defensive.

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The Hong Kong dollar was again trapped within relatively narrow ranges over the week with consolidation around the 7.8075 region. The local currency secured support close to the 7.81 level as arbitrage activity dipped beyond this level.

The local currency was hampered by a decline in regional economic and political confidence and a retreat in the Hang Seng index, especially when Wall Street fell.

Overall, the Hong Kong dollar should continue to resist loses beyond the 7.81 level against the US currency despite increased unease over the regional economic trends.

Chinese yuan:

The Chinese currency was confined to relatively narrow ranges against the US dollar over the week. There was evidence that the central bank was encouraging stability in the market, although there were suggestions that the authorities would deter losses.

In the NDF market, expectations of yuan appreciation over the next 12 months narrowed sharply to around 1.0% from levels above 12% earlier this year.

The German Finance Minister stated that the authorities had not agreed to let the Chinese currency strengthen at a faster pace, although the Euro did weaken significantly against the yuan over the week.

Unease over regional economic trends will tend to limit the extent of speculative capital inflows into the region and this should limit the scope for yuan gains.

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