Weekly Forex Currency Review 13-07-2012

The Euro-zone stresses and structural vulnerabilities will continue to be an extremely important market focus.  Markets were not convinced by the most recent EU Summit agreement, especially with an increased risk of delays in passing key ESM legislation in Germany.  Risk conditions are likely to be generally fragile on fears surrounding the global growth outlook, but speculation of additional Federal Reserve quantitative easing should help contain selling pressure.

Key events for the forthcoming week

Dollar:

The key US employment data was again weaker than expected which will hamper confidence in the US outlook. The Federal Reserve has edged slightly closer to further quantitative easing and speculation over further activity will curb dollar demand. There will, however, still be expectations that the US economy will out-perform the Euro-zone area in the short-term. Global factors will also be very important and a general lack of confidence in the outlook, allied with deleveraging within the banking sector, will still lead to defensive dollar support. In this environment, the US currency should be able to resist substantial selling pressure with volatility set to increase.

The dollar maintained a firm tone during the week despite the disappointing payroll data seen at the end of last week and it advanced to test two-year highs on a trade-weighted basis as the Euro came under pressure. International considerations remained important as global risk conditions were very fragile with a further flow into US Treasuries.

Minutes from the Federal Reserve meeting in June confirmed that there had been a wide-ranging debate and significant divisions within the FOMC. A few members continued to promote the case for further easing at this time. The majority were more concerned over the threat of a slowdown and also stated that further easing might have to be considered, but did not want to take immediate action.  There were also calls for a discussion on new methods to support the economy which suggests that there are important reservations over a further round of quantitative easing.

US jobless claims fell to 350,000 in the latest reporting week which was the lowest since the first quarter of 2008. Although the dollar failed to derive much immediate benefit from the data, there was further speculation that the US economy would out-perform Europe in the short-term.

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The Euro-zone leaders have made some progress in tackling the sovereign debt and banking crisis. There are, however, still major economic and political barriers, especially as it will be extremely difficult to move towards any form of banking union.  Prolonged delays in ESM implementation would also be damaging for confidence. Economic weakness will also be a key difficulty with expectations that austerity measures within Spain will deepen recession conditions further and increase political protests. The ECB will have to maintain an extremely loose monetary policy which will tend to keep the Euro generally on the defensive over the next few months.  

The Euro was subjected to further selling pressure during the week as structural fears continued with a slide to fresh two-year lows below 1.22 against the dollar.
 
The Eurogroup signed a political understanding with Spain and EUR30bn made available immediately to underpin the banks. There was also a pledge that Spain would be given an extra year to 2014 to cut the budget deficit to 3.0% of GDP. There were, however, still major uncertainties over policy details and the EU admitted that ESM stakes could not be taken before a Euro-zone banking Supervisor was in place.  

The German Constitutional Court held a hearing over the cases brought demanding an injunction to stop the ESM being ratified. In its opening statement, the Court stated that it would respect the decision of parliament, but the indications later in the day were that a decision could take weeks.

Spain announced a further EUR65bn package of measures to curb the budget deficit and attempt to cut the deficit to the target 3.0% target level by 2014.  The headline measure was an increase in VAT to 21% from 18%. There was a series of cuts to tax reliefs, although it was offset to some extent by a cut in income tax rates.

There was a series of labour-market protests to coincide with the fresh austerity measures and Prime Minster Rajoy was forced to admit that it was a measure of last resort. There was a decline in Spanish bond yields following the announcement, but there were also major concerns that fresh austerity measures would drag the economy deeper into recession.

There was a sharp decline in deposits held at the ECB according to the latest data as the new maintenance period started. In this context, the central bank decision last week to cut the deposit rate to zero had an important impact with pressure to reallocate funds elsewhere.  The Euro was still subjected to further selling pressure with increased speculation that the Euro would be used as a funding currency.

There were further warnings over Spanish regional budget deficits. Moody’s also downgraded the Italian credit rating to Baa2 which is only two notches above junk. There was further evidence of flows into defensive instruments such as AAA-rated bonds. The yield on Dutch 2-year bonds moved into negative territory, matching the trend in German and Swiss bonds

Yen: 

The Bank of Japan has resisted expanding monetary policy further at the latest policy meeting. With central banks expanding policy elsewhere, the net conditions have moved in favour of the yen.  Although the Bank of Japan will maintain a very loose policy, there will be reduced potential for selling pressure on the yen.  The Japanese currency will also gain important defensive demand at times given the deterioration in risk appetite and bond redemptions will also underpin the yen. There will still be a lack of confidence surrounding the domestic fundamentals and expectations of longer-term depreciation.   

The dollar was unable to sustain any headway during the week with resistance close to the 80 level while the yen held a firm tone on the crosses as the Euro retreated to lows below 96.50.

At its latest policy meeting, the Bank of Japan increased its asset-purchase programme to JPY45trn was JPY40trn previously, but also cut the loan programme by JPY5trn so the net quantitative easing programme was left on hold.  

With the ECB taking action to cut the deposit rate to zero and speculation that there could be additional Federal Reserve measures to boost quantitative easing, there was a shift in relative yield considerations in favour of the yen even though the Bank of Japan keeps interest rates near zero. There was the potential for relative yen out-performance, especially with the Swiss National Bank also blocking currency gains.

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There will be further concerns surrounding the UK growth prospects, especially with fears over the impact of weak demand within the Euro-zone. The UK currency has again been broadly resilient in the face of quantitative easing, but there will still be a high degree of unease surrounding longer-term implications with Sterling weakness a key feature of longer-term efforts to ease debt burdens. Safe-haven considerations will remain important and there will be scope for further inflows into Sterling if Euro-zone fears cannot be eased. Nevertheless, the Sterling environment could be increasingly unfavourable on domestic fears.

Sterling was unable to make significant headway against the dollar and dipped to one-month lows below 1.54. In contrast, Sterling pushed to levels beyond 0.79 against the Euro, the strongest level since late 2008.
 
The latest monthly industrial output data was stronger than expected with a 1.0% monthly gain which provided some relief, especially as the trade data was also stronger than expected as exports strengthened.

The NIESR, however, indicated that GDP dropped 0.2% for the second quarter and Bank of England Governor King maintained an extremely cautious outlook as he warned over the UK implications of sustained Euro-zone weakness.

UK benchmark yields fell to fresh record lows at the latest Gilt auction with a yield below 1.75% which reinforced speculation that there was defensive flows into UK bonds as capital continued to retreat from peripheral markets.

Swiss franc:

With confidence in the Euro-zone outlook remaining extremely weak, defensive flows into the Swiss currency are likely to continue, especially as the Euro-zone has found it very difficult to gain sustained relief. The National Bank is being forced to defend the minimum level on a daily basis and if pressure increases further there will be strong demands for the bank to consider capital controls or formal negative interest rates to weaken franc demand. There is still the medium-term possibility that the minimum level will be broken.

The Euro was unable to make any headway and the dollar pushed to 2012 highs above 0.9850 against the franc as European currencies remained on the defensive.

There will be further expectations that the National Bank will be forced to intervene aggressively to protect the 1.20 minimum level, especially with the Euro remaining under widespread selling pressure on the crosses.  There will also be further pressure for additional policy tools such as capital controls to ease pressure on bank intervention.

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The Australian dollar hit resistance close to the 1.03 level against the US currency during the week and retreated sharply to lows around 1.01 before finding some relief.

There were further concerns surrounding the global growth outlook which undermined demand for the Australian currency. There was also some disappointment that the Federal Reserve did not move closer to additional quantitative easing in the latest FOMC minutes. There was some relief that the latest Chinese GDP data did not meet the market’s worst fears.

Domestically, there was a much weaker than expected employment report which had some negative impact on sentiment while the Reserve Bank rejected notions that the currency was substantially overvalued.

The Australian dollar will find it difficult to sustain any significant advances given unease surrounding domestic and regional growth trends.

Canadian dollar:

The Canadian dollar was confined to relatively narrow ranges during the week with the currency unable to strengthen through the 1.0150 area against the US currency while there was support close to 1.0250.  

There were further concerns surrounding the global economic outlook which curbed demand for the Canadian currency. Oil prices proved broadly resilient during the week which provided some underlying support for the currency.

Important concerns surrounding the global economy and commodity-price trends will tend to limit scope for Canadian dollar gains even if oil prices prove resilient.

Indian rupee:

The Indian rupee found support on retreats beyond the 56 level against the US dollar with the currency unable to make much headway beyond 55.50.

There were further concerns surrounding the global economic outlook which hampered the rupee with risk conditions generally very fragile. The latest industrial production data was slightly stronger than expected which provided some degree of relief and there was also greater confidence surrounding reform prospects. In this environment, there was evidence of more robust international capital inflows which helped underpin the currency.

Doubts surrounding the regional economy will continue to limit the scope for rupee gains even if domestic confidence and reform optimism is slightly stronger.

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The Hong Kong dollar was unable to make any serious attack on the 7.75 band limit against the US currency and dipped towards 7.7575.  Underlying risk appetite was still generally fragile which dampened the potential for any gains from speculation that there could be a longer-term break of the currency peg.

Even with speculation over a medium-term policy shift, uncertainty surrounding the Chinese outlook should prevent serious near-term pressure on the peg.  

Chinese yuan:

The yuan remained generally on the defensive during the week with a spot rate around 6.37 against the US currency with the official fixing rate near 6.32. There were mixed economic releases during the week with a lower than expected CPI reading of 2.2% for June, allied with a decline in export and import growth. The latest GDP data recorded the slowest increase for over three years at 7.6%, but there was some relief that the data was not even weaker.

The latest balance of payments data recorded a decline in second-quarter foreign exchange reserves which increased speculation that there was an underlying capital-account deterioration.

The yuan is likely to be subjected to underlying selling pressure given a developing dollar shortage within the economy with the PBOC aiming to maintain stability.

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