Weekly Forex Currency Review 06-06-2008

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Overall strategy:

The central bank attitudes towards interest rates and currencies will remain very important market factors in the short-term. The tough ECB approach will provide short-term Euro support, but unease over the Euro-zone economy is likely to increase and divisions within European policymakers are also liable to widen.  Globally, fears over stagflation will tend to intensify which will contribute to volatile market conditions.                     

Key events for the forthcoming week

Dollar:

The overall tone of the US data will continue to offer some encouragement over underlying conditions with reduced fears, for now, over a further deterioration. The Federal Reserve has also indicated greater concern over the inflation outlook which will reinforce expectations that interest rates will not be cut further. The dollar will also gain support from the Fed's concern over the currency trends as it will reinforce expectations that G7 will look to curb any renewed dollar losses. The underlying situation will be fragile at best and any evidence of a sharp downturn would trigger a fresh slide in confidence.
 
From levels near 1.56, the US currency strengthened firmly to highs beyond 1.54, but there was then a sharp reversal. The dollar managed to hold some gains on a trade-weighted basis, although it retreated from the best levels.

As far as the US data releases were concerned, the ADP employment was above expectations for the third successive month with a reported private-sector employment increase of 40,000 for May after a revised 13,000 increase the previous month. Initial jobless claims also dipped to 357,000 in the latest week from 375,000.

The PMI index for the manufacturing index edged stronger to 49.6 in May from 48.6 previously month while pricing pressures remained very strong in the report.. Elsewhere in the manufacturing sector, there was a larger than expected increase in factory orders and the non-manufacturing PMI index held steady at levels above the 50.0 threshold which did not indicate recession.

Comments from Fed Chairman Bernanke had a substantial market impact. The Fed chief stated that the central bank was attentive to the impact of a weaker dollar on inflation and that the situation would be monitored very closely. The comments increased market expectations that there was now a more unified G7 stance to push for a stronger US currency or at least look to resist further losses.

Bernanke also stated that interest rates were at a comfortable level which reinforced speculation that the Fed would resist any further cut in interest rates. There was no hint of any potential move to tighten policy with futures market putting the chances of a small fourth-quarter rate increase at around 60%.

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The tough ECB stance will provide further near-term Euro support with some substantial speculation that the bank will increase interest rates next month. There will, however, also be increased unease over the Euro-zone economic conditions, especially as the recent data has been generally negative. In this environment, there will be fears that any monetary tightening would intensify the risk of recessionary conditions within several individual economies. There is also the threat of underlying investment outflows which will tend to unsettle the currency and limit the scope for gains.   
       
The Euro weakened during the first half of the week, but then strengthened sharply following the ECB council meeting with an advance against all major currencies.

The Euro-zone data remained generally weak with a further 0.6% reported decline in retail sales for April after a revised 0.9% decline the previous month. The final PMI indices were little changed from the preliminary data, with the Spanish and Italian figures well below the 50.0 contraction threshold.

In comments ahead of the monthly interest rate decision, the ECB maintained a tough stance on inflation and interest rates. At the council meeting, the ECB left interest rates on hold at 4.00%. In the press conference following the meeting, the ECB took a very hawkish tone on inflation by stating that inflationary pressures had increased.

ECB President Trichet also stated that there had been some calls for higher interest rates at the meeting with the decision to hold rates steady achieved by consensus. He then stated that the bank was in a heightened state of alert over conditions. A rate increase was considered a possibility and this could come as early as the July meeting, although it was not certain. In response to the comments, the Euro rose strongly against the US currency and also secured strong gains on the crosses.

Yen:  

The domestic economic trends are likely to remain generally weak in the short-term which will undermine yen confidence and yield support will remain at depressed levels which will unsettle the yen. The currency moves will, however, tend to be dominated by the trends in global markets. The yen will gain support if underlying risk appetite deteriorates on fears that the global economy will face stagflation conditions. Nevertheless, the Japanese currency will struggle to secure more than limited gains given the lack of yield support.  
                    
The yen gained some support during the week when stock markets declined and there were renewed fears over the financial markets. The yen was unable to sustain the gains and weakened to test three-month lows beyond 106.0 against the US currency.

There was further evidence of retail yen selling during the week as Japanese investors looked to target higher yields, but there were also sizeable inflows to domestic money-market funds which provided some currency protection.

There was a more cautious stance as fears over the global banking sector increased again with rumours that Lehman Brothers would announce a capital-raising share issue. There was also some further speculation over additional debt write-downs in the investment banks.

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Confidence in the economy will remain very weak in the short-term with further fears that deterioration in the housing sector will reinforce downward pressure on consumer spending and push the economy into recession.  The Bank of England will look to resist the pressure for lower interest rates in the short-term and there will, therefore, be some yield support for the UK currency. There is also scope for some investment flows, but underlying market sentiment is liable to remain very weak in the short-term.
 
Sterling remained under pressure during the week as confidence in the economy continued to deteriorate. The UK currency weakened to lows below 1.95 against the dollar and also dipped to 0.7970 against the Euro.

The UK data remained generally downbeat over the week and offered little encouragement to the currency. The PMI index for the manufacturing sector fell to 50.0 in May from 51.0 the previous month. The services-sector report also weakened with a dip to 49.8 from 50.4 the previous month, a five-year low for the index.

Consumer confidence also continued to weaken in the latest surveys while the construction PMI index fell to a record low of 43.9.  The Halifax Bank reported a drop in prices of 2.4% in May, maintaining the weak trend. The combination of reports will reinforce fears over a sharp slowdown in the economy.

The price indices remained high in the latest reports and inflation expectations also continued to increase in surveys which illustrated the bank's policy dilemmas.

Following the latest MPC meeting, the Bank of England left interest rates on hold at 5.00%. There was no statement and the vote was split was not announced.

Swiss franc:

The evidence from the manufacturing sector has suggested some degree of resilience in the economy. The higher than expected inflation data will also ensure that the National Bank will resist lower interest rates in the short-term. These factors will provide some degree of franc support, although overall currency direction is still likely to be determined by global markets trends. The Swiss currency will gain some support if there is any sustained escalation in financial-market stresses. Nevertheless, the franc will find it difficult to sustain strong gains from current levels.   
 
The Swiss franc drew support from a decline in risk appetite, but was unable to hold gains against the Euro and ended little changed against the US currency at close to the 1.04 level. The franc was unable to strengthen through 1.60 against the Euro.

Swiss consumer prices rose 0.8% in May with the annual inflation rate rising to a 15-year of  2.9%. The inflation data dampened any expectations that the National Bank would be in a position to cut interest rates in the short-term.

The Swiss PMI remained robust in the latest reading with a figure of  55.7 for May from 56.7 the previous month which stabilised confidence in the economy.

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The Australian dollar was again unable to sustain gains above the 0.96 level against the US currency, but corrective retreats again triggered firm buying support as commodity prices rallied firmly from weekly lows.

The first-quarter GDP data was stronger than expected with a 0.6% increase compared with expectations of a 0.3% increase.  In contrast, the retail sales report was weaker than expected with a 0.2% monthly decline for April.

Inflation expectations remained high according to the latest survey evidence and, although the Reserve Bank left interest rates on hold at the latest policy meeting, markets were still pricing in an interest rate increase later in 2008.

The Australian dollar will remain vulnerable to a steeper correction given the risk of volatile conditions in commodity markets, but underlying sentiment should remain firm in the short-term with buying support on dips.

Canadian dollar:

The Canadian dollar has had a consistently weaker tone over the week with losses to lows beyond the 1.02 level against the US currency before a tentative recovery.

The Canadian currency was undermined in part by an overall drop in commodity prices over the week, although there was a significant recovery late in the week.

The Canadian dollar was still being undermined by the weak GDP data recorded at the end of last week with the first quarterly contraction for five years.

After some initial support from an improvement in risk appetite, renewed unease over the financial sector helped push the Canadian currency weaker, although uncertainty was a key feature as stock markets looked to rebound.

The Canadian currency is likely to face tough resistance on any near-term renewed gains towards parity against the US currency.

Indian rupee:

The rupee was unable to make any significant headway during the week and drifted back towards the 43.0 level against the US dollar before consolidating around 42.75.

The rupee was initially hampered by a firmer US currency trend while overall risk appetite was also generally lower. These trends were reflected in a generally weaker capital account with estimates that outflows had amounted to around US$1.5bn over the past two weeks.

The rupee gained some support as the US currency reversed course and there was speculation that the central bank was looking to increase interest rates to curb inflationary pressure which supported the Indian currency.

Overall, the rupee should be able to resist heavy losses from current levels unless there is a renewed surge in oil prices, but with limited scope for gains.   

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The Hong Kong dollar has again traded with a weaker tone and was consistently weaker than the central rate of 7.80 against the US dollar with lows close to 7.81 against the US currency.

The Hong Kong currency was unsettled by a generally firmer US dollar over the week while there was less confidence in Asian currencies.

A cautious tone in the local stock market also undermined the Hong Kong dollar, but there was some recovery on Friday as US currency positions were cut back.
 
The Hong Kong dollar should be able to resist losses from current levels against the US currency as arbitrage activity will dip sharply. 

Chinese yuan:

The yuan weakened back towards 6.95 against the dollar during the week as the US currency firmed, but it then regained strength with a sharp move to 6.924 on Friday as the US currency was subjected to renewed selling pressure.

There was further speculation that export growth was slowing an that the central bank would look to curb underlying yuan appreciation. There were also continuing expectations that the authorities would look to promote market volatility in order to order to discourage speculative inflows

Commercial banks were also instructed to stop offering margin trading for retail Chinese yuan trading to help curb speculative activity.

Overall yuan volatility levels are liable to increase over the next few weeks. There is still scope for net currency gains even though the bank will look to engineer significant depreciation at times to prevent expectations of consistent gains.    

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