Weekly Forex Currency Review 08-08-2008

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Overall strategy:

There will be further concerns over the global economy in the short-term with a particular focus on deteriorating conditions within the Euro-zone. These international fears will continue to provide dollar support, especially if commodity prices continue to weaken. The US economy will, however, remain in a very fragile condition which will limit the potential for dollar gains, especially if consumer conditions deteriorate.

Key events for the forthcoming week

Dollar:

The latest data has maintained the recent generally indecisive trend. The economy is showing some resilience, but there is little prospect of a sustained recovery at this stage and credit difficulties could still lead to a deep recession. The Federal Reserve is more concerned over inflation, but will be reluctant to increase interest rates in the near term with yield support remaining weak. The US currency should continue to secure some support on structural grounds, especially with increasing unease over the global economy. There is also the potential for defensive capital inflows which will underpin the currency.           

The dollar again secured a firmer tone over the week and strengthened to a 6-month high on a trade-weighted basis while also pushing through June's highs against the Euro. The US currency took advantage of increased fears over the global economy.

The US currency was also underpinned by a sharp decline in commodity prices over the week as fears over a decline in demand put downward pressure on prices.

Following the employment decline of 51,000 for July released at the end of last week and an increase in unemployment to 5.7% from 5.5%, the growth-orientated data releases have remained subdued with no clear direction.

The PMI index for the services sector rose to 49.5 from 48.2 previously while the underlying components were mixed. There was a recovery in the employment index, but inventories rose which suggests that growth will be weak in the short-term.

The labour-market data remained weak with initial jobless claims rising to a fresh five-year high of 455,000 in the latest week, the second successive reading above the 420,000 level. The figure is likely to have been inflated again by a change in the qualifying rules, but unease over the labour market persisted.

The core PCE index recorded a 0.3% increase for June while the annual rate rose to 2.3%. This is significantly above the Fed's 1-2% target range.

As expected, the Federal Reserve held interest rates at 2.00% following the latest FOMC meeting. There was a 10-1 vote with Fisher again dissenting and calling for a hike in rates to curb inflation expectations.

The statement was not changed radically from the previous meeting with the Fed uneasy over both growth and inflation aspects. The inflation situation was described as highly uncertain with considerable concern while the labour market had softened further. There was no major impact on interest rate expectations.

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Fears over the Euro-zone economy will continue in the near term. The evidence continues to suggest the threat of a deep recession in countries such as Spain while there will also be increased fears over the German economy. This will be critical given the German importance to the Euro-zone economy as a whole. The ECB will remain uneasy over inflation, but the bank may take a more moderate stance later this quarter, especially if there is a further decline in oil prices. Overall, the Euro remains vulnerable to underlying selling pressure.           
       
The Euro was weaker as confidence in the Euro-zone economy deteriorated further with losses against all the major currencies and lows below 1.52 against the dollar.

There was a further dip in retail sales for June with the annual decline at a record 3.1% as income levels continued to stagnate. The Euro-zone Sentix index also weakened to -15.3 in July from -9.3 and this was the lowest reading for over five years. The PMI services sector index was also confirmed at a five-year low for July.

There was a sharp decline in German factory orders for the June while there were also reports of a 1.0% GDP contraction for the second quarter although this followed a strong reading for the first quarter.

As expected, the ECB left interest rates at 4.25% at the latest council meeting. In the press conference, President Trichet reaffirmed that the bank would take a firm tone on inflation. Trichet also remarked that growth had slowed substantially over the middle of 2008 as risks had materialised. Markets tended to focus on the growth comments which helped spark a rally in bond prices and also weakened the Euro sharply.

Yen:  

Confidence in the Japanese economy will remain weak, especially with officials expressing the fear of recession, and there will also be wider fears over the Asian economy. Crucially, the yen will remain vulnerable on yield grounds with the potential for substantial capital outflows. There will still be caution over aggressive yen selling given the global economic fears. A decline in commodity prices would also be a net positive for the currency. The dollar will look to extend the advance, but gains are liable to be measured from current levels.
                    
The Japanese currency rallied at times, but there was further strong evidence of selling on rallies. With the US currency also generally firmer, the yen weakened to the lowest level against the dollar since January.

The economic data was slightly stronger than expected with the dip in machinery orders for June held to 2.6% following a large increase previously. There was also a small quarterly increase, but companies were downbeat over third-quarter plans. Bank lending held firm in the data which did not suggest a serious credit crunch.

Government officials downgraded their assessment of the economy and warned that the economy could be in recession which undermined sentiment.

The sharp Australian and New Zealand dollar declines helped underpin the yen slightly, but there was still evidence of capital outflows from Japan on yield grounds.

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Recession fears will continue to increase in the short-term following a string of weak data releases throughout most sectors, although the prime focus will be on the housing trends. The Bank of England will continue to face a very difficult task over the next few months and Sterling will weaken sharply if there is any hint of lower interest rates even if the bank is forced to hold steady in the near term. Fears over the Euro-zone economy will continue to provide some significant degree of Sterling protection against the Euro. 

The UK data remained generally depressed over the week and this helped maintain a weaker bias for the currency. Sterling weakened to 17-month lows against the dollar below 1.93 while it was generally confined to narrow ranges around 0.79 against the Euro before strengthening on Friday.

The PMI services index edged higher to 47.4 for July from 47.1 previously, but this was the third consecutive figure below the pivotal 50.0 level. The construction PMI index also weakened to a record low of 36.7 which continued to suggest serious contraction within the housing sector.

There was further evidence of a major weakness in the housing sector with the Halifax Bank reporting a 1.7% drop in prices for July to give an 8.8% annual decline. Consumer confidence dipped to record lows in the latest monthly survey.

The IMF issued a downbeat report over the economy, cutting GDP growth forecasts for the next two years, and also warned that Sterling was liable to fall further.

The Bank of England held interest rates at 5.00% for the fourth successive month at the latest policy meeting. There was no statement following the meeting and the vote breakdown was also not announced.

Swiss franc:

There will be further expectations of an economic slowdown, especially after a further downturn in the PMI index, although the data at this stage has not signalled a severe downturn. The franc will remain vulnerable on yield grounds, especially if there is a sustained recovery in risk appetite. Overall, despite showing a slightly more resilient tone against the Euro, the Swiss currency is likely to remain vulnerable to some further underlying selling pressure. 

The Swiss franc found support weaker than 1.6350 against the Euro over the week. It was generally on the defensive against the dollar with lows beyond 1.07 as the US currency secured a wider recovery.

Overall confidence in the European economy deteriorated which also tended to undermine demand for the franc.

The Swiss PMI index edged lower to 54.1 in July from 54.9 and this was the weakest reading in over three years, although it was slightly higher than expectations and a more robust reading than elsewhere in Europe.

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The Australian dollar was subjected to sharp selling pressure over the week and dipped to four-month lows against the US dollar with lows below 0.9000.

The Reserve Bank of Australia left interest rates on hold at 7.25% at the latest policy meeting, but the bank also suggested that rate cuts may be required over the next few months. The switch to an easing policy bias helped trigger heavy currency selling.

There was further evidence of weakness in the construction sector, although housing prices fell by less than expected during the second quarter. The services-sector PMI index also continue to weaken for July with a slide to 42.8 from 45.4 previously while there was another weak reading for the construction sector. The labour-market data provided some of relief with a 10,000 increase in employment for July, although the unemployment rate was slightly higher than expected at 4.3%.

The Australian dollar will be at risk of further losses if there is sustained downward pressure on commodity prices, especially as domestic doubts have increased, although a near-term technical correction is realistic.

Canadian dollar:

The Canadian dollar weakened further over the week with accelerated losses. It depreciated for the sixth successive weak against the dollar while it tested support levels beyond 1.05 against the US dollar. A sharp drop in commodity prices was an important negative influence on the Canadian dollar over the week.

There were no major data releases in Canada during the latest week. The PMI index dipped from the elevated reading for July, but it held comfortably above the 50.0 threshold. In contrast, there was a sharp decline in building permits which maintained underlying doubts over the housing sector.

The Canadian dollar will remain vulnerable if commodity prices continue to decline, but there should be scope for a limited corrective recovery.

Indian rupee:

The Indian currency retained a slightly firmer tone, but it was still unable to sustain gains through the 42.0 level against the US currency as the dollar firmed widely.

The trend in commodity prices was generally favourable for the Indian currency with a sharp decline in oil prices, although crude did rally from its lowest levels.

There were advances for the local stock market to a 7-week high as the drop in commodity prices was boosted by a general recovery in risk appetite. There was still evidence of an underlying lack of confidence which curbed currency support.

A sustained decline in oil prices would continue to improve the rupee's risk profile, but rupee gains are liable to be limited as underlying sentiment remains fragile. 

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The Hong Kong dollar continued to edge weaker during the week with a dip to a 8-week low around 7.8090 on Friday as the US currency secured a wider advance.

The Hong Kong currency was undermined to some extent by a generally firmer US currency tone in global markets. Local inter-bank rates were also low which curbed short-term support for the currency.

The Hong Kong dollar should be able to resist losses much beyond current levels with arbitrage level fading on any move above 7.81 against the US currency.

Chinese yuan:

The central bank continued to guide the yuan to lower levels over the week. Moves were still restrained and the primary influence was a general rally in the US currency. The Chinese currency dipped over successive days to lows around 6.87 on Friday

The authorities announced changes to the foreign exchange rules with companies allowed to keep more currency overseas while the rules surrounding overseas investments would also be relaxed. This increased speculation over a slightly weaker underlying capital account as action against speculative inflows also continued.

There was also further speculation that the authorities would look to curb yuan appreciation as growth fears continued to become a more important influence.

The underlying rate of yuan appreciation is liable to slow over the next few month while the authorities will also look to promote near-term stability.

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