Weekly Forex Currency Review 17-12-2010

Liquidity levels will tend to diminish in the short-term ahead of the Christmas and New Year period. This may confine major currencies to narrow ranges, although volatility and erratic trading conditions will also be an important threat, especially if there are further stresses within Euro-zone capital markets.            

Key events for the forthcoming week

Dollar

The dollar will continue to gain some support on yield grounds with optimism that the economy can expand at a faster pace in 2011.  The Federal Reserve is still likely to maintain a highly expansionary monetary policy which will limit the scope for dollar support. There will also be a persistent unease over the structural vulnerabilities, especially with ratings agencies raising fears that the US will eventually lose its AAA credit rating. The monetary-policy stance will also maintain expectations that the dollar will continue to be used as a global funding currency.  The dollar will therefore remain dependent on weakness elsewhere to make much headway. 

 
The dollar was able to maintain a firm tone against the Euro, but was unable to break Euro support below 1.32 and failed to make much headway on a trade-weighted basis.

The US retail sales data was stronger than expected with a 0.8% headline increase for November following a revised 1.7% gain previously while there was an underlying 1.2% increase. The data reinforced expectations of a firmer trend in consumer spending, especially with some evidence of looser credit conditions.

The other growth-orientated data also continued to offer some degree of support with industrial production rising 0.4% for November while the New York manufacturing index rose strongly back into positive territory with a reading of 10.6 for December. Although the housing starts data was subdued, but jobless claims maintained the recent favourable tone with a small decline to 420,000 in the latest week from 423,000 previously. The Philadelphia Fed manufacturing index was significantly stronger than expected with a rise to 24.3 for December from 22.5.

The producer prices data was also stronger than expected with a 0.8% monthly increase with a 0.3% core increase and bond yields rose following the data. The consumer inflation reading was benign with a 0.1% reading, but there was still a rise in US Treasury yields to a 7-month high of 3.56% which helped underpin the dollar.
The Federal Reserve left interest rates on hold in the 0.00-0.25% range and it also maintained its commitment to the US$600bn bond-buying programme. Although the statement was slightly more upbeat surrounding growth prospects, it also stated that the performance was not sufficient to cut unemployment. The dollar gained some relief from the unchanged policy, but the statement was still generally dovish.

There will still be unease surrounding the structural vulnerabilities with a third-quarter current account deficit of US$127bn reminding investors that the US is running substantial external deficits as well as the budget deficit.

The structural US vulnerabilities were illustrated by a warning from ratings agency Moody’s that the US fiscal plans including an extension of tax cuts would significantly increase the risk of a medium-term downgrading of the existing AAA credit rating.

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The Euro-zone structural vulnerabilities will remain an extremely important focus over the next few weeks at least. EU leaders have managed to stem fears to some extent, but it will still be very difficult to secure a sustained improvement in market conditions as medium-term fears surrounding the Euro area will persist. There will also be further speculation surrounding the Euro’s medium-term future. The ECB will also find it very difficult to exit from special liquidity measures which will curb Euro support. Overall, it will be difficult for the Euro to secure more than a limited recovery.

The Euro remained vulnerable during the week, but did recover from its worst level as markets took some note of official reassurances over the medium-term outlook. The German economic data also maintained a firm tone with a ZEW business confidence index rise to 4.3 for December from 1.8.

The Euro was dogged by structural fears. There was a report that Standard & Poor’s could cut the Belgian credit ratings which reinforced market fears over the contagion risk. The Euro also lost support following a warning from ratings agency Moody’s that the Spanish credit rating was on negative watch due to a rising debt burden and financing concerns. Markets will remain extremely sensitive to the contagion threat within the Euro-zone area given fears over the long-term Euro outlook.

At the EU Summit, there was agreement to bring in a new Euro support mechanism in 2013 while the ECB also announced that it would raise additional capital to help boost its ability to buy bonds. Of particular importance was the ability to avoid public disagreements within the Summit, but there will still be fears that underlying tensions will return.

There were also fears that a heavy debt-roll-over schedule in 2011 will effectively freeze Portugal out of the debt markets which would also maintain a high risk that the country would eventually also need EU support.

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Underlying confidence in the Japanese economy will subdued at best and there will be further pressure any yen gains to be resisted in order to underpin the competitive sector, especially in view of weaker business confidence. There will be caution over aggressive capital outflows from Japan, especially given a lack of  confidence in the Euro-zone and US economies, although there will be pressure for some outflows given the low domestic yields. Without substantial capital outflows, the yen will be resist to heavy selling pressure.

The trends in US Treasury markets remained important with the dollar continuing to gain support from a rise in yields and there was a test of resistance above 84.40 in Asian trading on Thursday, but the US currency was unable to break through.

Domestically, the headline Tankan business confidence index rose fell to 5 for the fourth quarter from a reading of 8 previously and this was the first decline for two years, although it was slightly better than expected. The data will certainly maintain unease over economic trends, but an early response from the Bank of Japan looks unlikely as it waits for further developments.

There has been some downward pressure on global stock markets which should offer some degree of yen protection and there will still be a lack of confidence in the Euro-zone outlook which will maintain the potential for capital repatriation from the Euro by Japanese institutional investors. Exporter selling was also a feature above the 84 level and resistance levels remained tough to break down.

Sterling

There will be expectations of a sharp economic slowdown during the first quarter of 2011 as tax increases take effect and there will be strong pressure on the Bank of England to maintain a highly-expansionary monetary policy which will curb Sterling support. There are also likely to be increased fears that the central bank will lose control over inflation which would trigger medium-term currency losses. There should still be some degree of protection from a lack of confidence in the Euro-zone and US outlook. High volatility is likely to remain an important feature given swings in sentiment.   

Sterling edged weaker during the week as whole with a test of support below 1.5550 against the dollar while the Euro was able to strengthen to above the 0.85 level.

The UK consumer inflation rate was higher than expected with the headline rate rising to a six-month high of 3.3% from 3.2% previously, contrary to expectations of a small decline. The retail prices index also rose to 4.7% from 4.5% previously.

The UK unemployment claimant count was close to expectations with a slight decline for November, but the ILO-based unemployment data was weaker than expected with an increase to 7.9% from 7.7%.  The data overall should not cause undue alarm in isolation and the latest CBI retail sales report was at the strongest level since 2002. Officially, retail sales rose 0.3% for November following a revised 0.7% advance the previous month.

Bank of England MPC member Sentence maintained his call for higher interest rates but Sterling failed to sustain the initial advance. There are fears that growth will slow sharply at the beginning of next year as tax increases take effect and there are also fears that the Bank of England will risk losing control of inflation given the need to support demand.

The latest Bank of England inflation expectations survey also had a significant impact with a rise in one-year expectations to 3.9% from 3.4% previously. The rise will tend to increase pressure for the central bank to raise interest rates.

There were still be doubts whether the central bank would be in a position to tighten policy given the loan-repayment burden and there will also be fears that the Bank of England will lose medium-term control of the economy.   

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International developments will remain extremely important in the short-term and the franc will maintain defensive support on a lack of confidence in the Euro-zone. There is also a possibility of much more substantial capital flight into the Swiss currency if Euro-zone tensions intensify again. The National Bank will maintain a steady policy in the short-term, although there will be pressure for the central bank to resist further franc appreciation. Overall, the franc should remain resilient in the short-term.

The franc weakened at times during the week, but it quickly recovered losses and pushed to a fresh record high against the Euro and Sterling The dollar also tested support below 0.96 against the franc during the week.
The Swiss National Bank held interest rates at 0.25% following the latest council meeting and there were minor changes to the economic forecasts. The bank warned over potential damage from Euro fragility, but there were no measures to directly influence the franc’s value.

There was a small improvement in the ZEW economic sentiment index. The central bank clearly remains sensitive to the franc’s value and would be looking to increase interest rates if the currency was weaker.

Australian dollar

The Australian dollar briefly strengthened to above parity against the US dollar, but was unable to sustain the advance and retreated back to the 0.9850 area before settling above 0.99.

Domestically, there was some speculation that the Reserve Bank could increase interest rates again during 2011. There were also concerns over a slowdown in consumer spending which tended to stifle currency support and there will also be unease over the possibility of further Chinese monetary tightening.

Australian dollar volatility is liable to remain relatively high given the potential for sharp fluctuations in domestic and international sentiment. Resistance levels are likely to remain strong on any move to the parity area against the US currency.

Canadian dollar

The Canadian dollar resisted selling pressure during the week and made a further challenge on US dollar support close to parity before settling in the 1.0050 area.

The Canadian currency drew support from strength in oil prices and some optimism over firmer North American demand, but there were concerns surrounding competitiveness and there were also Bank of Canada warnings over the domestic debt levels which curbed demand to some extent.

It will remain difficult for the Canadian dollar to sustain any move beyond parity especially if there further market concerns over domestic and global debt levels.

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The rupee was confined to relatively narrow ranges during the week and consolidated in the 45.60 area against the US currency. The Euro was generally fragile which tended to curb rupee support, but the US currency also struggled to gain any traction which encouraged a period of consolidation.

The Reserve Bank of India left interest rates on hold following the latest monetary policy meeting and this tended to have a positive impact on the rupee as there were increased capital flows into the stock-market.

The rupee should prove to be broadly resilient in the near term and the most likely outcome is for a period of quieter trading with reduced capital flows.  

Hong Kong dollar

The Hong Kong dollar found support on dips towards 7.78 against the US dollar, but was unable to strengthen back through 7.77 as underlying sentiment was fragile with US Treasury bond yields remaining higher.

There was some speculation that concerns over the Chinese property market could trigger capital inflows into the Hong Kong share market, but there was no immediate evidence of a beneficial impact on the currency..

The Hong Kong dollar will lose ground when international risk appetite deteriorates, but optimism over underlying capital inflows should provide some support.

Chinese yuan

The yuan was confined to small moves during the week and consolidated slightly weaker than 6.66 against the US currency with a slightly weaker Euro encouraging a weaker Chinese currency.

The central bank appeared very satisfied with the narrow range and official comments continued to suggest that the authorities would aim for stability. Lower capital flows ahead of the Christmas period made it easier for the bank to contain currency moves.

There will be persistent expectations that yuan appreciation will accelerate in the medium term, but further consolidation is likely in the short-term.

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