Weekly Forex Currency Review 06-05-2011

Overall strategy: Market volatility is likely to remain an important short-term feature, especially with over-extended speculative positions against the US currency. There is likely to be a close focus on Asian economic policies in the short-term, especially with pressures for further action to curb inflation. Any increased tolerances of currency appreciation within Asia would tend to ease selling pressure on the US currency against European currencies.   

 Key events for the forthcoming week

Market analysis

Dollar: 

There will be some unease over US economic trends, especially with a sharp downturn in the non-manufacturing PMI index.  Even if growth holds firm, there will be strong expectations that the Federal Reserve will maintain a very accommodative monetary policy over the next few months. This will curb US yield support and there will also be serious concerns over the medium-term budget position, especially with political wrangling the debt ceiling. The US currency will gain support on valuation grounds and there will be firm backing on any deterioration in risk appetite, especially given the high number of speculative short positions.

The dollar remained under heavy selling pressure over the first half of the week and retreated to fresh 3-year lows on a trade-weighted basis. It then secured a sharp recovery as there was a closing of short dollar positions as commodity prices fell.

The latest US economic data was again sharply weaker than expected with an increase in jobless claims to an eight-month high of 474,000 in the latest week from a revised 431,000 previously. The data triggered a deterioration in risk appetite and there was also a very sharp correction in commodity prices as oil prices fell by over US$12 per barrel to below US$100 and there was a very sharp reduction in short dollar positions.

The headline US ADP employment report was slightly weaker than expected with a 179,000 private-sector job gain for April following a revised 207,000 increase the previous month. The figure dampened expectations surrounding the Friday payroll release, although the impact was subdued.

There was a much bigger reaction to the ISM non-manufacturing report which recorded a sharp decline to 52.8 for April from 57.3 the previous month. There was a sharp decline in business activity and new orders which will certainly cause concern and there was also a significant weakening in the employment component.

Fed officials took a generally dovish tone towards the economy and monetary policy in comments during Wednesday. The US data will reinforce expectations that the central bank will resist any move to tightening policy and there may be some fresh speculation over additional quantitative easing.

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Markets had priced in a substantial amount of ECB tightening and with the central bank taking a more cautious approach in the latest press conference, the currency will be vulnerable to profit taking as yield support eases.  Structural considerations will also remain important and the Euro will be extremely vulnerable if there is a contagion effect on Spain and France.  The existing yields will support the Euro at times and there will also be support from a lack of confidence in the dollar. Overall, given the risk profile, the Euro will still find it hard to sustain current valuations or extend gains.

The Euro continued to advance ahead of the ECB policy meeting with expectations that the central bank would take a strong tone and signal a further near-term interest rate increase.

Portugal announced that it had agreed a EUR76bn bailout package, but attention was focussed more on other countries, especially with some speculation that core Euro-zone economies could be subjected to selling pressure.

There was no surprises with the ECB decision with interest rates on hold at 1.25%. In the press conference following the decision, President Trichet stated that policy was still very accommodative and that the inflation risks were still to the upside. These comments suggested that the central bank was still expecting to tighten policy further over the next few months.

Trichet also stated that developments would be monitored very closely. In the coded messages delivered by the central bank, this suggested that interest rates would not be increased at the June meeting with the bank giving itself more time to assess the situation, especially with very important structural vulnerabilities. The comments and a decision to maintain extraordinary liquidity measures triggered a reassessment of interest rate expectations and also triggered downward pressure on the Euro.

The combination of short dollar covering and a corrective retreat in the Euro pushed the Euro sharply lower with the biggest decline for eight months as it weakened to lows near 1.45 against the US currency.

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The economy will remain very weak in the short-term and the Bank of Japan will maintain an extremely loose monetary policy to support demand. From a longer-term perspective, overall confidence in the government-debt situation will also remain extremely fragile as the debt situation remains perilous.  There will tend to be net institutional capital flows overseas which will weaken the yen. The currency will still gain important support at times when risk appetite deteriorates and there is an unwinding of carry trades. Overall, the yen will find it difficult to sustain significant gains.

Tokyo markets were closed for a holiday for much of the week as part of the Golden Week holidays which dampened trading activity. There were further expectations of medium-term capital flows out of Japan and fears over the domestic debt situation.

The evidence suggests that there has been strong fund buying of the US currency over the past few sessions, but the dollar failed to gain any traction. There was a further dip in US yields which undermined the dollar.

The yen maintained a strong tone on the crosses during Thursday as risk appetite deteriorated and there was a sharp decline in commodity prices. The dollar also came under heavy selling pressure and weakened to lows near 79.50, the weakest point since March’s G7 intervention.

There was market speculation over renewed intervention to weaken the yen. The Japanese Finance Ministry stated that it was watching market conditions very closely, but also that the situation was different from that in March

Sterling:

The run of weaker than expected survey data will reinforce a lack of confidence in the economy and will also maintain expectations that the Bank of England will be extremely slow to raise interest rates. Sterling will, therefore, be vulnerable on yield grounds and there will also be fears that aggressive fiscal tightening will trigger a more severe downturn in the economy.  The UK currency will continue to gain protection from serious doubts surrounding the US dollar and fears over the Euro-zone structural outlook. Sterling will find it difficult to make net gains against the US currency.

Sterling was unable to break above 1.6750 against the US dollar during the week and retreated to lows near 1.6350. There was support beyond 0.90 against the Euro.

The PMI index for manufacturing declined to 54.6 for April from a revised 56.7 the previous month and this represented a seven-month low for the series. The construction index weakening to 53.3 for April from 56.4 the previous month. The services-sector index fell to 54.3 for April from 57.1 previously, maintaining the run of poor survey evidence this week.

Mortgage lending remained subdued and there was another weak reading for money supply which will maintain fears over weak consumer spending.  The NIESR also downgraded its GDP growth forecasts and stated that the shortfall would prevent the government from meeting its borrowing forecasts.

As expected, the Bank of England left interest rates on hold at the latest MPC meeting. There was no statement following the decision and the vote split will not be released for two weeks. Following the weaker than expected data, there was a further scaling back of interest rate expectations which undermined yield support with further concerns that interest rates are negative in real terms.

International trends tended to dominate in the New York session with the sharp Euro decline helping Sterling to recover from lows beyond 0.90 as ECB rate expectations were also downgraded. Sterling weakened to temporary lows near 1.6350 against the dollar as a function of wider US gains.

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International considerations will continue to dominate in the short-term. The Swiss currency will remain the ultimate safe-haven, especially with all major alternatives suffering from weak sentiment and fears over longer-term debasement and this will trigger underlying flows into the franc, particularly when fears over the Euro intensify.  The franc’s movements will also tend to remain correlated strongly with trends in risk appetite and there will be further demand for the currency when equity markets weaken. There will be the potential for verbal National Bank intervention to curb excessive gains.

The dollar hit further record lows against the franc with a trough near 0.8550 before a sharp recovery in choppy trading conditions. A deterioration in risk appetite boosted demand for the Swiss currency and yield spreads against the Euro also narrowed following the ECB press conference which pushed the Euro to lows below 1.2650.

The franc will tend to gain further support if there is a sustained deterioration in risk appetite, especially as the National Bank, rather surprisingly, has not indicated any major protests over the franc’s level at this stage.

Australian dollar:

The Australian dollar maintained a strong tone over the first half of the week and hit a fresh 29-year peak at the 1.10 level against the US dollar. The currency was unable to sustain the gains and retreated very sharply to lows near 1.0520 in volatile trading before a recovery to the 1.07 area. There was a deterioration in risk appetite and a sharp corrective decline in commodity prices.

The Reserve Bank left interest rates on hold at 4.75% at the latest policy meeting. The bank statement was generally dovish, but there was a more robust tone in the monetary report with a suggestion that interest rates could be increased further.

There will be strong-buying support for the Australian dollar on retreats, but it will be very difficult to reach new highs against the US currency.

Canadian dollar:

The Canadian dollar maintained a strong tone over the first half of the week with a further test of support beyond 0.95 against the US dollar. The currency retreated alter in the week with a dip towards support in the 0.97 area as oil and commodity prices were subjected to a sharp reversal.

The domestic economic data was mixed with a rise in building permits and international considerations tended to dominate.

The Canadian dollar is liable to drift weaker given that it remains over-valued and there will be sharper losses if commodity prices continue to retreat.

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The rupee was unable to secure significant advances during the week and dipped sharply late in the week with a decline to a 5-week low in 44.80 area against the US currency. The rupee was undermined by a weaker Euro and a sharp deterioration in risk appetite as equity markets were subjected to sharp losses.

There was a surprise from the Indian central bank with a 0.50% increase in the main interest rate compared with an expected 0.25% hike. There was a negative impact on stock-market sentiment, but there was some increase in short-term yields which supported the yield.

Given the domestic and international risk profile it will be difficult for the rupee to advance strongly, but selling should be contained.

Hong Kong dollar:

The Hong Kong dollar strengthened to a peak just beyond 7.7650 against the US dollar before weakening back through the 7.77 level.

There was a deterioration in risk appetite during the week as equity markets came under pressure which curbed demand for the Hong Kong dollar. There was also some disappointment over reduced IPO offerings which curbed demand for the currency.  

Longer-term revaluation speculation and expectations of a stronger Chinese yuan should protect the Hong Kong dollar from strong selling pressure.

Chinese yuan:

The yuan maintained a stronger net tone over the week and advanced to beyond the 6.50 level against the US currency. The yuan was unable to sustain the gains and edged weaker, especially after the Euro came under pressure.

There was further speculation that the Chinese yuan could be included in the SDR basket which maintained speculation over a greater medium-term international role for the currency.

There was further speculation that the Chinese authorities would sanction further interest-rate increases to control inflation, although there were mixed signals from unofficial comments.

There is scope for a steady yuan appreciation, although the central bank may slow the rate of monetary tightening which would slow the yuan’s advance.