Weekly Forex Currency Review 14-09-2007

Overall strategy

Given the sharp deterioration in US economic conditions and amount of Fed easing already priced into the markets, the dollar should be able to avoid heavy losses from current levels unless the data flow is extremely weak. High-yield currencies will struggle to extend recoveries much beyond current levels given the underlying credit stresses.      

Key events for the forthcoming week

Dollar

Confidence in the economy will remain very fragile in the short-term with further fears over the wider impact of housing-sector weakness. The Federal Reserve interest rate decision will be the key short-term event and there is a strong chance of a cut, although the Fed may well be more cautious than expected by markets. There will be some defensive demand for the US currency if risk aversion intensifies again. With Fed rate cuts to 4.50% already discounted for this year, the US dollar should be able to secure some protection, but strong gains are unlikely until there is evidence of housing-sector stabilisation.   
      
The dollar has remained under pressure over the past few days with sentiment undermined sharply following last week's much weaker than expected payroll report.

The dollar weakened to lows beyond 1.39 against the Euro and tested levels close to 1.18 against the Swiss franc. The trade-weighted index fell to a fresh 15-year low.

The very weak payroll report last week recorded a 4,000 drop in employment, the first drop in over four years, while unemployment held steady at 4.6%.

The jobless claims data this week was more encouraging with claims little changed at 319,000 in the latest week from a revised 315,000 previously.

Fed Governor Mishkin, who is close adviser to Chairman Bernanke, stated that there were important downside risks to the economy which reinforced market speculation of a more aggressive cut in interest rates at the September 18 FOMC meeting

Bernanke, himself declined to make specific comments on the economic risks or interest rate policy in comments this week.

The US trade deficit narrowed to US$59.2bn for July from an upwardly- revised US$59.4bn the previous month with the export performance remaining strong.

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The firm ECB stance and possibility of another interest rate increase will underpin the Euro in the short-term. The Euro-zone economy is liable to prove brittle, with particular vulnerability surrounding the housing sector and rate expectations are liable to be scaled back. There is also likely to be increased tensions between the ECB and national governments if evidence of weakening growth coincides with further euro gains. The Euro should still be well placed to avoid heavy losses unless there is an escalation of banking-sector difficulties.             

The Euro retained a firm stance over the week and appreciated against most major currencies. As well as gains against the dollar, the Euro also regained further ground against the yen with a move to 160.

The ECB remained generally firm stance towards the economy by stating that there are still inflation risks while monetary policy remains on the accommodative side. This stance was reiterated by key ECB officials such as President Trichet in speeches during the week.

Firmer French industrial production data provided some relief to the market, but Spanish Finance Minister was generally cautious over the economic outlook

The German IFW institute lowered its 2007 GDP growth forecasts to 2.7% from 3.2% and business sentiment indices were generally weaker.

Yen 

The yen will remain vulnerable to selling pressure if risk aversion eases, especially as there will be persistent retail capital flows from Japan in search of high yields. Markets are not expecting the Bank of Japan to tighten policy this month and a rate increase would, therefore, be likely to jolt the Japanese currency stronger. The underlying credit-related stresses will also continue to provide important yen support. Any further Chinese monetary tightening would tend to support the Japanese currency and, overall, the dollar will struggle to secure more than limited further gains.                 
                    
The yen strengthened to highs beyond 113.0 against the dollar, but was unable to sustain the gains and weakened back to lows above 115.0 ahead of the US sales data.

The yen was unsettled briefly by the resignation of Prime Minister Abe, especially with markets speculating that political uncertainty would discourage the Bank of Japan from raising interest rates.

There was a strong increase in core machinery orders for Japan with a 17.0% monthly increase. The jump in orders helped offset the negative yen impact of a downward GDP revision to show a contraction for the second quarter.

The wholesale prices data recorded a 1.9% annual increase in prices, but  futures markets signalled that the chances of an interest rate increase were close to zero.

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There will be increasing speculation that the Bank of England will not increase interest rates further, especially as market interest rates remain higher. There are also likely to be further housing-sector slowdown and evidence of a sharp slowdown would increase pressure for a cut in interest rates within the next few months. Sterling trends will also remain correlated with global risk aversion levels and any improvement in sentiment towards high-yield currencies would provide at least temporary Sterling support. Nevertheless, the net economic risks suggest that the currency is liable to weaken during the Autumn period.               
 
Sterling weakened to 14-month lows against the Euro with a slide to 0.6875 before a recovery back to 0.6835. Volatility levels against the dollar also remained higher with highs above 2.0350 before a retreat to below 2.02.

Bank of England Governor King stated that the bank was in a wait and see mode on interest rates and that rates could be adjusted quickly if necessary.

Sterling was unsettled by the RICS survey which reported a drop in house prices for the first time in close to two years while a mortgage company filed for administration.

The UK currency also dipped sharply after the Northern Rock lender announced that it was securing emergency funding from the Bank of England.

There was a further small monthly decline in unemployment while average earnings growth edged higher to 3.5% in the year to July from 3.4% previously.

There was increased speculation that the Bank of England would not increase interest rates again from 5.75% with some speculation over a rate cut next year.

The trade deficit widened significantly to GBP7.1bn in July from a revised GBP6.5bn the previous month

Swiss franc

The National Bank interest rate increase will underpin the currency in the short-term, especially with most major central banks either holding rates steady or considering a cut. The Swiss fundamentals should also remain strong which will help underpin the currency. The franc will tend to be sold if there is a sustained improvement in risk tolerances and it will be seen as an attractive funding currency at times, but heavy selling pressure looks unlikely with net gains against European currencies.    
 
The Swiss franc tested levels near 1.18 against the dollar before dipping after failing to break this level. The Swiss currency also weakened to near 1.65 against the Euro.

The Swiss National Bank increased interest rates by 0.25% to 2.75% following the latest quarterly council meeting.

The central bank lowered its inflation forecasts slightly for 2007 with little change for the following two years. The bank also expressed further concerns over the impact of the weak franc.

A tentative recovery in risk appetite helped lessen demand for the Swiss currency over the week as a whole despite further volatility.

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Despite high volatility, the Australian dollar had a generally firmer tone over the week and pushed to highs above 0.84 against the US currency.

The domestic data suggested a slowdown in the property sector with a drop in housing starts and finance for August, although the immediate impact was limited. Business and consumer surveys were still generally optimistic over prospects.

Expectations of lower US interest rates helped fuel demand for the Australian dollar on yield grounds as the yield spreads widened.

Rising global stock markets helped the Australian currency secure greater benefit from improved yield differentials.

Australian yield support will provide additional support if risk tolerances improve, but the net credit risks suggest that strong currency gains are unlikely.

Canadian dollar

The Canadian currency continued to gain ground against the US dollar with a peak close to 1.03 before a slight retracement.

The Canadian dollar drew further support from the strength of oil prices which pushed to record highs over the week at close to the US$80 p/b level.

The trade surplus narrowed to CAD3.7bn for July, but this failed to have a significant market impact.

Bank of Canada Governor Dodge stated that the domestic economy was running above capacity, but that monetary policy was appropriate with uncertainty over the impact of financial-market turbulence.

The Canadian dollar should remain firm in the short-term, but will find it difficult to secure further significant gains.

Indian rupee

The rupee strengthened over the week as a whole as confidence in the currency gradually recovered. The currency pushed towards 40.45 late in the week.

There was caution evident ahead of the US Federal Reserve meeting, but evidence of a recovery in capital inflows into the Indian equity market helped support the rupee.

The industrial data was weaker than expected with a 7.1% increase in the year to July which increased fears over competitiveness. The central bank acted to cap rupee gains through intervention during the week

Rupee confidence should remain firm in the short-term on optimism over capital inflows, but the currency is still likely to weaken slightly over the next few weeks.

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The Hong Kong dollar has remained generally firm over the past week, although movements have been subdued with the Hong Kong dollar hitting resistance beyond the 7.79 level against the US currency.

There was some evidence of a covering of short US dollar positions even though sentiment remained generally weak.

There was strong demand for funds ahead of forthcoming IPO offerings with notable interest ahead of the Sino-Ocean Land Holdings. Demand for funds pushed money-market rates higher and supported the currency.

There was some evidence of corporate US dollar buying during the week which helped underpin the currency.

Although, the Hong Kong dollar will still find it difficult to strengthen significantly further against the US currency, significant losses look unlikely.

Chinese yuan

The Chinese currency has strengthened significantly during the week with gains to around 7.512 against the US dollar on Friday. The yuan traded stronger than the central bank's reference rate.

The Chinese economic data strongly pointed to a firmer Chinese currency and the central bank allowed gradual appreciation.

The trade surplus rose to US$25.0bn in August which was the second highest surplus on record. The consumer inflation rate was also greater than expected with the inflation rate rising to a 10-year high of 6.5%.

There was speculation over a further increase in interest rates to curb over-heating pressures in the economy, especially after the inflation data.

The net trend is still likely to be for a stronger Chinese yuan, especially with continuing pressure for a tighter monetary policy to curb domestic overheating. There is also likely to be increased speculation over a one-off currency revaluation.