Weekly Forex Currency Review 15-08-2008

Overall strategy:

There will be further concerns over global economic conditions in the short-term with speculation over a sharp slowdown in growth. These international fears will continue to provide important dollar protection, especially if commodity prices continue to weaken, although it will be difficult to strengthen much further in the near term. There is the risk of a further capitulation in high-yield positions funded through the yen.

Key events for the forthcoming week

Dollar:

The most recent data has generally maintained the recent indecisive trend. There is still important evidence of resilience, although the main supportive evidence is still coming from exports rather than the domestic economy. As the impact of tax rebates fade, there will be renewed unease over the consumer spending outlook. The Fed will be reluctant to tighten monetary policy, especially if energy prices continue to decline, although they will need to monitor inflation trends closely. The primary source of any further dollar strength is still likely to be from increased fears over the global economy rather than domestic confidence.

Following the dollar surge at the end of last week, the US currency retained a firm tone, although it was difficult to extend gains as the currency was over-bought. The US currency still gained on a trade-weighted index for 11 consecutive days and pushed to a six-month high near 1.4720 against the Euro.

The dollar again took advantage of lower oil and commodity prices over the week as there was an important underlying shift in market sentiment.

US retail sales edged lower by 0.1% in July as auto sales weakened with a 0.4% underlying increase while there was a small upward revision to June's data.

The US trade deficit fell to US$56.8bn for June from a revised US$59.2bn the previous month. There was a 4.0% increase in exports for the month which was the strongest increase for over four years. Following the trade data, there were upward revisions to the second-quarter GDP estimates on a positive export contribution.

Consumer prices rose a headline 0.8% in July after a 1.1% increase the previous month as food and energy prices continued to increase with the 5.6% year-on-year increase the highest for 17 years. There was also a second successive 0.3% increase in core prices with the annual core rate at 2.5% which maintained inflation fears.

Despite the inflation data, there was no great shift in interest rate expectations with markets sceptical that the Fed would be in a position to tighten policy while major doubts over the economy persisted, especially as credit stresses persisted.

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The second-quarter GDP contraction for the Euro-zone will reinforce fears over the economy with sentiment liable to weaken further in the near term. There will be particular fears surrounding economies such as Spain which are under severe pressure. There will be further speculation that the ECB will switch towards a policy relaxation within the next few months. There is also the threat of capital outflows, but some Euro correction is realistic after sharp losses with some interest by central banks to diversify reserves.           
       
The Euro was generally weaker as fears over the growth outlook intensified, although it recovered from lows against the yen in choppy trading conditions.

There was a 0.5% decline in German GDP for the second quarter, although this was slightly stronger than expected following the first-quarter surge. In contrast, the French economy contracted 0.3% in the quarter which was worse than expected and overall Euro-zone GDP fell by 0.2%, the first quarterly decline since the Euro area was created. Industrial production stagnated in the latest monthly data.

The ECB monthly report was very similar in content to the bank comments last week with warnings that growth had slowed while there were still upward pressures on inflation. Officials maintained a cautious tone over growth in remarks over the week.

The final consumer inflation estimate was slightly below the flash estimate at 4.0% from the 4.1% expected while the core rate was at 1.7%. There was increased speculation that the ECB would shift to a less restrictive policy later in 2008.

Yen:  

Confidence in the Japanese economy will remain weak, especially after the confirmation of a second-quarter contraction which will reinforce recession fears. The shift in global capital flows will remain very important in the short-term. A lack of confidence in the global economy will provide some degree of support to the currency with the potential for a further reduction in carry trades funded through the yen. There will still be important yen selling interest on rallies given the yield structure with volatility remaining higher. 
                    
The yen found support weaker than the 110.30 level against the dollar during the week and strengthened to highs around 108.35 despite wider dollar strength. The yen strengthened to below 162.0 against the Euro before losing ground again.

Global capital flows were important with evidence of some liquidation in carry trades as global growth fears increased and commodity prices came under pressure. The latest capital account data also recorded strong net inflows into Japan with some speculation over capital repatriation of coupon payments.

The second-quarter GDP data recorded a 0.6% decline, the weakest outcome for seven years and reinforced the suspicion that the economy had entered recession. Overall consumer confidence also weakened to a record low according to the latest data, reinforcing fears over the consumer spending outlook while the monthly Tankan business confidence index dipped to a fresh 5-year low

Wholesale prices rose 7.1% in the year to July which was the highest figure for 27 years, but there were no real expectations that the bank would respond with higher interest rates given the recession fears.

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Recession fears will continue to increase in the short-term following persistently negative data releases. Confidence in the economy and currency has also been damaged further by the Bank of England inflation report and markets have shifted expectations towards expecting a cut in interest rates before the end of 2008. The deterioration in Euro-zone economic conditions will continue to provide significant protection to the UK currency while Sterling has also discounted a substantial amount of economic weakness.   

The UK currency remained under strong pressure during the week with the trade-weighted index retreating to the lowest level for 11 years. The UK currency weakened for 11 successive days against the dollar with lows around 1.8550 while Sterling dipped sharply from levels near 0.78 against the Euro.

The growth-related data remained generally weak over the week. The BRC retail sales monitor recorded a 0.9% drop in like-for-like sales for July while the latest RICS house-price index recorded a further decline in activity. There was a further increase in unemployment of over 20,000 for July which was the largest increase for 16 years.

As far as inflation is concerned, the headline consumer inflation rate rose sharply to 4.4% from 3.8% the previous month while the core rate rose to 1.9% from 1.6% and the Retail Prices index was above 5.0%. Headline earnings growth moderated to 3.4% in June from 3.6% the previous month as bonus payments came out of the calculation.

In its quarterly inflation report, the Bank of England warned that inflation would peak close to 5.0% this year, but would then fall sharply and would be slightly below the 2.0% level in two years time assuming rates were left unchanged.

The bank downgraded its growth forecast for the economy and Bank Governor King was notably downbeat over the economic prospects with warnings over a difficult year ahead. Following the report, markets moved towards pricing in an interest rate cut before the end of 2008 which kept the UK currency under pressure.

Swiss franc:

The sharp downturn in consumer confidence will reinforce speculation over a sharp downturn in the economy and overall sentiment will remain fragile. The wider Euro-zone fears will continue to provide some relative franc protection against the Euro. Any further erosion of carry trades would also tend to provide some degree of support to the Swiss currency. Overall, there is scope for a franc correction stronger against the dollar, although substantial gains look unlikely.

The franc retained a weaker tone against the dollar during the week and was probing levels close to 1.10 on Friday. The franc struggled to sustain gains beyond 1.6180 against the Euro, but proved resilient as the Euro struggled.

The Swiss currency gained some degree of support from a reduction in high-yield positions, although the moves were still restrained.

The Swiss consumer confidence indicator weakened sharply to -17 in the third quarter from +2 the previous quarter which reinforced expectations over a weak economy with some speculation that the National Bank could cut interest rates in September.

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The Australian dollar remained under heavy pressure and retreated to 7-month lows near 0.86 against the US dollar with recoveries quickly attracting selling interest.

The Reserve Bank of Australia's monetary report confirmed that the bank had effectively switched to a easing policy bias with markets assuming that interest rates will be cut within the next few months.

The Australian dollar was subjected to sharp selling pressure as expectations of lower interest rates increased. The trends in commodity prices were also very important with  decline in metals prices adding to the underlying selling pressure on the currency.

There was some stabilisation in business and consumer confidence according to the latest data which helped stabilise the currency, although sentiment remained fragile.

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 to lows beyond 1.07 against the dollar as the US dollar rallied, but it found some relief over the second half of the week. The currency fluctuated in line with crude oil prices, although the overall impact was still measured.

The trade account remained in comfortable surplus for June at US$5.8bn and overall confidence towards the economy remained slightly stronger, at least in relation to the wider global economy, as international fears increased.

The Canadian dollar will remain vulnerable if commodity prices come under further pressure, but there should be scope for a limited corrective recovery.

Indian rupee:

The rupee retained a weaker tone and dipped to a 1-month just beyond the 43.0 level on Thursday with activity on Friday curtailed by a national holiday. The Indian currency was undermined by general US currency strength over the week.

Further losses in the rupee were limited by speculation over Reserve Bank intervention to support the currency. The bank also reported that there had been US$7bn of intervention during June to curb currency depreciation.

There was some unease following a partial recovery in oil prices while underling confidence in the stock market remained fragile on fears over underlying outflows.

A sustained decline in oil prices would help underpin the currency, but there looks to be little prospect of substantial rupee gains in the near term.

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The Hong Kong dollar dipped sharply at the end of last week as there was a general surge in the US currency. The local currency retained a weaker tone this week with a fresh 1-month low near 7.8150 against the US currency.

Demand for the currency dipped following the end of the IPO offerings and this contributed to the weak tone for the local currency.

Overall confidence in the Hang Seng index and was also still fragile which curbed underlying demand for the currency and Asian currencies were generally weaker.

Despite weaker sentiment, the Hong Kong dollar should still be able to resist losses much beyond 7.8150 against the US currency with reduced arbitrage activity.

Chinese yuan:

The yuan weakened slightly, although moves were restrained in the context of wider dollar gains. There was further evidence of the central bank controlling movements in the currency and it retreated to around 6.87 against the dollar.

The latest economic data failed to have a major impact on the currency with a US$25.3bn surplus for July while producer prices inflation was at 10.0%. There was further speculation that policy would be switched towards supporting the economy and away from inflation fighting as the economy cooled.

The central bank announced that it would create a new foreign exchange department to set exchange rate policy and this maintained underlying speculation that yuan appreciation would slow. There was an important shift in the NDF markets with markets expecting gains of 2.5% over the next 12 months. 

The underlying rate of yuan appreciation is still liable to slow over the next few months as growth considerations become the dominant influence.

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