Weekly Forex Currency Review 18-07-2008

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Overall strategy:

Confidence in the US economy will remain fragile with further speculation that there will be an underlying shift away from the US currency. Nevertheless, a substantial amount of bad news has been priced in while the dollar remains attractive on valuation grounds. Fears over the European economy is also likely to increase which should offer important dollar protection with sharp shifts in investor sentiment.                    

Key events for the forthcoming week

Confidence will remain fragile given fears that housing-sector weakness will trigger a more severe downturn in the US economy. Reduced expectations of any Federal Reserve interest rate increases will also tend to undermine the dollar. The latest data has, however, shown some degree of resilience and sentiment could turn sharply, especially as the Fed will also be looking at inflation trends. There will be speculation over central bank resistance to further losses and any sustained oil price decline would tend to be a net positive influence. Overall, the dollar should be able to resist heavy selling pressure from current levels.      

The dollar weakened sharply early in the week with the trade-weighted index at three-month lows while the US currency also recorded a fresh record low against the Euro at near 1.6040. The dollar was able to stage a limited rally later in the week.

The financial sector was a very important market focus over the week. Following the aggressive selling of US mortgage finance companies Fannie Mae and Freddie Mac at the end of last week, the Treasury and Fed announced that further support would be supplied if required with expanded credit lines and possible injections of equity.

Confidence remained extremely fragile, but there was some recovery later in the week. The latest earnings results from the investment banks also provided some relief despite losses at Merrill Lynch.. Crude oil was unable to sustain gains to a record high and then weakened sharply which also helped underpin the dollar.

US consumer prices rose by a stronger than expected 1.1% in June as energy prices rose strongly to give a 5.0% annual increase which was the highest rate for 16 years. There was a 0.3% core increase for the month to give a 2.4% annual increase. Producer prices rose by a further 1.8% over the month for a 9.2% annual rise.

Retail sales rose 0.1% in June while there was a 0.9% increase in underlying sales as car sales weakened sharply. The New York and Philadelphia Fed manufacturing indices stayed in negative territory for July while industrial output rose 0.5% in June.

In testimony to Congress, Fed Chairman Bernanke reinforced the message that the US economy faces major difficulties with downside growth risks. He also pointed to increased inflation risks and stated that the outlook was highly uncertain. Bernanke put a slightly greater focus on inflation in the second half of his testimony.

Although 2008 GDP growth estimates were actually revised up slightly from the previous estimate, expectations of higher interest rates continued to fade. Markets were close to pricing out any increase in the Fed funds rate over the remainder of 2008 compared with expectations of at least three increases seen during June.

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Sentiment towards the Euro-zone economy is liable to deteriorate as the German economy weakens, especially as there are even more serious fears over the outlook for other Euro-zone economies. The ECB will continue to take a tough stance on inflation which will reinforce the Euro's near-term yield support. There will, however, be the risk of further capital outflows while internal stresses and policy divisions are liable to increase. In this environment, Euro advances from current levels are likely to attract substantial selling pressure.         
       
The Euro secured strong gain early in the week before being subjected to a significant correction. There was evidence of solid buying support on dips.

The German ZEW business confidence survey continued to weaken with a decline to -63.9 in July from -52.4 which was a fresh record low for the survey. There was a sharp decline in industrial production for May, although the impact was limited as individual country reports had already been reported.

There were further warnings over the economic outlook from the Spanish government and overall confidence remained very fragile. June inflation for the Euro-zone was confirmed at 4.0% while the core rate increased to 1.8% from 1.6% previously

ECB officials retained a firm tone on inflation in comments during the week with Wellink warning that slower growth would not necessarily lower inflation. The degree of rhetoric was significantly lower than in recent weeks while ECB President Trichet warned over the economic slowdown. He also warned over the inability to respond to individual countries within the Euro framework.

Yen:  

Yield considerations will remain very important in the short-term and, while the Bank of Japan maintains a very low interest rate environment, there will be further interest in overseas high-yield instruments which will tend to undermine the yen. The degrees of risk aversion will remain very important and the yen will be more vulnerable to capital outflows if there is a sustained recovery in risk appetite. The currency will still gain intermittent support on elevated risk aversion while there are likely to be calls for a stronger yen from within Europe.   
                    
The yen strengthened to highs beyond 104.0 against the dollar as the US currency weakened and risk aversion spiked higher. The yen also regained ground against the Euro, but then weakened sharply with a move back to 107.0 on Thursday.

The Bank of Japan left interest rates on hold at 0.50% following the latest interest rate decision and there was no suggestion that the bank was moving towards an increase in rates in the near term with unease over potential downside risks.

The yen gained support from an increase in risk aversion during the week as global equity markets remained under pressure with a sharp decline in prices. There was still evidence of strong Japanese interest in overseas bonds with reported sales by individuals at the highest level for over 11 months.

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The evidence continues to suggest that the economy is weakening with most sectors facing pressure as the housing sector continues to deteriorate with a sharp decline in transactions. Headline inflation data has moved sharply higher and the Bank of England will face a series of very difficult policy decisions as it battles growth and inflation stresses. The UK currency will gain some support on yield grounds if the bank maintains a tough stance and there should also be some protection from fears over the US and Euro-zone outlook. In this environment, Sterling may prove resilient, but is unlikely to secure strong support. 
 
Sterling found support weaker than the 0.80 level against the Euro and strengthened back towards the 0.79 level, although it was unable to strengthen through this level. The UK currency struggled to sustain levels above 2.00 against the dollar.

The annual consumer inflation rate increased strongly again for June with an increase to 3.8% from 3.3% the previous month as food and energy prices continued to rise strongly. The core inflation rate also edged higher to 1.6% from 1.5% previously.

The labour-market data recorded an employment claims rise of 15,000 in June from 14,300 previously which reinforced expectations of a sharp economic slowdown. 

The latest RICS data recorded that close to 90% of surveyors reported lower housing prices during June. A key feature, however, was that transactions were at the lowest level on record which increased fears over the housing sector. There was a 0.4% decline in annual like-for-like sales according to the latest BRC retail survey.

MPC member Sentance stated that he had been struck by the speed that inflation had risen while there was no convincing evidence that the economy was slowing at a faster pace than assumed in the May inflation report. Markets overall were sceptical that the bank would look to increase interest rates given the economic vulnerability.

Swiss franc:

There will be further concerns over the Swiss financial sector and there has been evidence of deterioration in confidence. Yield support remains weaker and the franc will be sold if there is a sustained recovery in risk appetite. The Swiss currency will still gain some support if there is a renewed surge in risk aversion and fears over the global financial sector. Overall, the franc is likely to hit tough resistance close to the parity level against the US dollar.

The franc strengthened to a 3-month high against the dollar with a peak close to parity before a retreat back to 1.02. The franc also briefly tested levels below 1.60 against the Euro before a significant retreat towards 1.62.

The Swiss franc gained support from a decline in risk appetite, especially as equity markets were subjected to sustained selling pressure. Conditions eased later in the week, especially as oil prices weakened sharply from record highs.

Domestically, there was a strong report for retail sales for the month with a 7.4% annual increase which eased immediate economic fears. In contrast, the latest ZEW confidence survey recorded a further decline to -76.9 from -63.8 the previous month.

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The Australian dollar tested fresh 25-year highs against the US currency with a peak close to the 0.9850 level before a corrective retreat back towards 0.9650.

The Reserve Bank minutes from July's meeting stated that growth should moderate while bank Governor Stevens also stated that monetary policy should be tight enough to contain inflation. There was reduced speculation that interest rates would increase further which undermined the currency to some extent. There was also evidence of weakness in the housing sector which was a negative currency influence.

The evidence of capital inflows from Japan on yield grounds was offset by some downward pressure for a decline in commodity prices.

Overall sentiment should remain firm in the short-term with support on yield grounds, but the Australian dollar will struggle to make much headway from current levels.

Canadian dollar:

The Canadian dollar tested levels beyond parity against the US currency for the first time in six weeks with a peak close to 0.9980. The Canadian currency was unable to sustain the gains and weakened back to around 1.0050.

The Bank of Canada left interest rates unchanged at 3.0% following the latest council meeting. The bank warned that inflation could rise to 4.0% over the next few months, but took a generally neutral view on short-term prospects for interest rates.

Manufacturing shipments were stronger, but the currency was still hampered to some extent by the employment decline reported at the end of last week. The negative impact of lower oil prices was offset by a recovery in risk appetite.

The Canadian dollar is likely to hit further tough resistance close to the parity level against the US currency, although losses should be contained.

Indian rupee:

The Indian currency was able to find some further degree of stability during the current week with support weaker than the 43.0 level against the dollar and stabilisation around 42.80 late in the week as sentiment improved slightly.

Stock market conditions were volatile, but risk aversion faded slightly over the week which underpinned the market and also supported the rupee There were reduced fears of further capital outflows after net selling of around US$7.2bn this years. The currency also gained some support from a sharp drop in oil prices.

The latest wholesale inflation rate rose to 11.9%, maintaining the potential for further Reserve Bank tightening which supported the currency on yield grounds.

A sustained decline in oil prices would improve the rupee's risk profile, but fragile confidence in the economy and rupee is likely to limit the scope for currency gains. 

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The Hong Kong dollar was confined to narrow ranges close to the 7.80 level during the week, although it had a slightly firmer tone with a level around 7.7980 on Friday.

The Hang Seng index recovered over the week and this provide some degree of support to the Hong Kong dollar. Inter-bank rates were still relatively low on ample liquidity which curbed strong demand for the currency.

Sharply reduced expectations over higher US interest rates should offer important protection to the Hong Kong dollar even if gains are limited.

Chinese yuan:

The yuan retained a firm tone against the dollar during the week, strengthening to a fresh post-revaluation high of 6.81 before edging back towards 6.82 on Friday.

The data suggested a slowdown with GDP growth at 10.1% in the second quarter of 2008 from 10.8% previously and this was the slowest rate of increase for thee years. Consumer inflation slowed to 7.1% in June from 7.7% the previous month.

There were increasing fears over the export outlook and increased demands for the  yuan appreciation policy to be curbed. The Chinese Securities Journal, for example, called for a shift in policy, although there was evidence of a robust policy debate.

Markets were also cautious over aggressive buying with speculation that the bank would seek to trigger at least a temporary reversal in yuan to curb speculation.

The authorities are liable to curb further yuan appreciation in the short-term and the overall rate of yuan gains is also likely to slow.  

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