Weekly Forex Currency Review 26-09-2008

Overall strategy:

Markets will continue to focus heavily on financial-sector stresses and progress towards a US rescue package with the lack of dollar liquidity having an important short-term impact.  An agreement would ease immediate fears surrounding the US position and could give some support to the dollar, although the impact would be offset by evidence of further deterioration in the US fundamentals.

Key events for the forthcoming week

Dollar:

The severe financial-market stresses will tend to remain dominant in the short-term and agreement on a US support package would provide relief. The recent US economic evidence suggests the threat of a renewed downturn in activity and this will be an important setback to the dollar given expectations that the US would be the first global economy to emerge from recession conditions. The US currency will still gain some support from a greater reluctance to invest in emerging markets and a general lack of confidence in growth prospects elsewhere which will limit the scope for losses. 

Conditions within the US financial markets continued to dominate over much of the week. The mood of uncertainty contributed to choppy trading conditions and also made it difficult to secure a decisive trend. The dollar secured a net corrective tone following sharp losses the previous week and settled around 1.46 in nervous trading.

Following the announcement late last week, the Treasury continued to push for congressional agreement over a US$700bn support package for the financial sector.
Political tensions increased later in the week with President Bush stark in his warnings over the severe negative impact if an agreement was not reached.

Congressional leaders inched towards an agreement, although uncertainties persisted and there were fresh difficulties late on Thursday as a group of Republicans looked to promote an alternative package amid acrimonious talks.

Fed Chairman Bernanke was generally downbeat over the economic prospects. He stated that growth would be likely to be substantially below potential over the second half of 2008. Market stresses could be a considerable drag while commercial real-estate loan conditions had tightened substantially. Bernanke also stated that recent inflation news had been slightly more favourable.

Money-market tensions remained extreme and global central banks aggressively provided liquidity to help ease these strains and allow markets to function.

There were only limited US data releases over the first half of the week. The pace of releases then picked up and had a generally weak tone. Existing home sales dipped slightly to an annual rate of 4.91mn from 5.02mn the previous month while prices were lower. The latest national survey also recorded a further decline in house prices.

The was a sharp 4.5% decline in durable goods orders for August while initial jobless claims continued to increase to 493,000 in the latest week. Although there may have been distortions from hurricanes, the evidence suggested an underlying deterioration.

In view of the depressed data releases, markets moved to price in around an 80% chance of an interest rate cut at the October FOMC meeting.

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The further deterioration in confidence surveys will reinforce expectations that the Euro-zone economy will slide into recession in the short-term. The ECB remains determined to dampen any risk of higher underlying inflation and will want to maintain a tough stance on interest rates to keep wage settlements under control. There will, however, be growing pressure for a relaxation of interest rates which will curb Euro support. There is also the risk of further investment outflows from the Euro-zone which will undermine support.               
       
The Euro retained a firm tone, but struggled to extend gains after the sharp advance seen the previous week, while regional economic concerns were a notable feature.

The German IFO index weakened further to 92.9 in September from 94.8 the previous month and the institute was generally pessimistic over prospects. The IFO staff also stated that the ECB should move towards a cut in interest rates.

The latest PMI releases recorded a further deterioration in conditions with the composite index dipped to the lowest level since 2001. The current account deficit narrowed over the month while there were further outflows on the capital account.

The ECB remained concerned over the inflation outlook and was continuing to focus on the secondary inflation risks surrounding wage developments. There was an increase in political pressure for a more accommodative monetary policy with Spanish Finance Minister Solbes calling for the ECB to move to cutting rates.

Yen:  

Confidence in the domestic economy will remain weak in the short-term and there will be fears over underlying deflation within the economy.  Severe stresses within the global economy will continue to provide important backing to the currency with further caution over capital flows into high-yield assets. The Japanese banking sector should also remain less vulnerable to global credit stresses which will underpin the currency.  The yen will lose ground if there is a credible agreement on a US support package.
                   
The Japanese currency retained a slightly weaker tone for much of the week as underlying risk aversion was at a reduced level. The US currency failed to make strong headway against the Japanese currency. Tensions in the equity markets were lower which lessened near-term demand for the yen, but money-market tensions and uncertainty remained at an extremely high level. The yen strengthened towards 105.50 against the dollar late in the week as the US negotiations hit difficulties.

The Bank of Japan injected liquidity into the domestic money market for the first time to help alleviate the major stresses. The central bank was very cautious over the outlook with warnings on economic conditions and the risk of deflation.

Aso was elected as the new Prime Minister and attention was paid to the cabinet appointments, although the impact was limited with attention focussed elsewhere.

The domestic data failed to have a major impact with the latest quarterly manufacturing survey suggesting some improvement. The trade account moved into deficit for August as export growth faltered and upward pressure on import costs. Core nationwide inflation was held at 2.4% in August.

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The economy is set to weaken further in the short-term with severe stresses in the housing sector and a continuing squeeze on disposable incomes. The Bank of England will face a series of very difficult policy decisions over the next few months. The MPC will want to maintain a tough stance on inflation, but the overall risks suggest that it will move to lowering interest rates relatively quickly.  There should be some investment support for the capital account which will lessen the risk of substantial selling pressure on the currency.

The UK currency pushed to a 1-month high around 1.8650 against the dollar during the week, but then dipped sharply back towards 1.83. Sterling was also unable to sustain gains beyond 0.79 against the Euro with a retreat to 0.7960.

The UK housing data remained weak with BBA mortgage approvals falling to a fresh record low in August. The latest CBI retail survey recorded a further sales decline during September, although the decline was less than that seen the previous month.

MPC member Blanchflower reiterated his forecast of a further sharp rise in unemployment while he again called for a sharp reduction in interest rates. There were mixed comments from other MPC officials with both Sentence and Barker warning over the risks to growth and inflation. The net balance of comments suggested that there were increased fears over economic conditions, although uncertainty within and outside the MPC was high.

Swiss franc:

The evidence suggests that the Swiss economy will continue to slow as domestic demand and exports come under further pressure.  There will also be further concerns over the domestic financial sector which will tend to erode franc support. Defensive demand for the currency will also tend to decline if market stresses ease, but underlying caution will tend to prevail which should act to limit losses unless there is a serious deterioration in domestic banking conditions.  

The dollar found support on dips to 1.07 against the franc and recovered back to 1.09 with a general tone of consolidation. The franc was slightly weaker against the Euro, but movement was relatively limited and the Swiss currency gained renewed support late in the week as risk aversion spiked as US financial talks hit difficulties.

There were no significant domestic developments over the week with attention firmly on global market trends.

A general easing of fear within the global equity markets curbed near-term demand for the Swiss currency, although underlying stresses were still very important and fear was again the dominant influence on Friday.

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The Australian dollar pushed to a high of 0.85 against the US currency before encountering tough resistance and dipping back towards 0.8250 late in the week.

The domestic data continued to suggest an underlying slowdown in the economy, although the impact was limited with no major releases while the Reserve Bank suggested that interest rates would be cut only slowly.

The currency drew initial support from gains in gold prices, although commodity prices struggled to sustain advances in the face of increased global economic fears.

The Australian dollar has scope for a limited advance against the US currency, but rallies are liable to stall relatively quickly given underlying market fears.

Canadian dollar:

The Canadian dollar had a firmer tone against the US currency over the week and strengthened to test 1.03, the strongest level since early August before consolidating around 1.0350 in nervous trading.

The Canadian currency drew some support from the generally weaker US dollar tone and a measured recovery in risk appetite, although caution prevailed.

Consumer prices fell 0.2% in August which while there was a core rise of 0.3% to give an annual increase of 1.7%. There was a solid increase in retail sales July which did not have a significant market impact. The comments from Bank of Canada Governor Carney suggested that the central bank had an easing bias on interest rates.

The Canadian dollar should retain a firmer tone in the short-term, although it will be difficult to make much headway from current levels.

Indian rupee:

The rupee resisted a further test of 2-year lows near 47 against the dollar during the week, but struggled to make much headway and was close to 46.40 on Friday.

The local currency was hampered by month-end demand for the US dollar, especially as liquidity conditions were tight. There was evidence of central bank support on any retreat towards the 47 level.

Underlying confidence remained fragile with regional equity markets finding it difficult to make strong headway with overseas banks also looking to buy dollars.

Confidence in the economy and region is liable to remain very fragile. In this environment, the rupee is liable to remain generally vulnerable in the near term.

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The Hong Kong dollar retained a firm tone over the week and pushed to highs near 7.76 against the US dollar as local inter-bank rates spiked higher. The HKMA again intervened in the market to boost liquidity and this helped pull the local currency from highs and it was close to 7.7750 on Friday.

The latest trade data recorded declines in export and imports which undermined confidence in economic prospects and sentiment towards the economy remained weak

Overall, the Hong Kong dollar will struggle to extend gains, especially as underlying regional capital inflows are liable to remain weaker on economic doubts.

Chinese yuan:

The yuan was unable to make headway over the week with further evidence that the central bank was resisting any upward pressure on the currency and it dipped to lows near 6.85 on Friday following a sharp daily decline.

The NDF markets briefly shifted to show market expectations of depreciation over the next 12 months for the first time in over two years. They reverted to show expectations of only very slow appreciation as underlying sentiment was weaker.

There was further speculation that the authorities would continue to move towards a policy of supporting the economy and stepping back from inflation control.

Unease over the domestic and regional economic trends will continue to limit the scope for near-term yuan appreciation with the central bank likely to promote near-term stability given the domestic and international uncertainties.    

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