Weekly Forex Currency Review 18-02-2011

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Overall strategy:  Inflation pressures and the international responses to rising costs will continue to be an important global focus in the short-term.  It will be difficult for Asian countries to resist interest rate increases, but they will also be very concerned over potential speculative capital inflows which would increase the threat of capital controls. The extent of political protests on the back of rising food prices will also be watched closely and risk conditions are liable to fluctuate sharply.          

 Key events for the forthcoming week

 Market analysis

Dollar: 

The US economic data has continued in much the same vein with overall evidence of firm growth despite some disappointment surrounding individual releases.  The dollar will continue to gain some support from higher yield grounds, but this will also continue to be offset by expectations that the Federal Reserve will not move to tighten policy over the next few months. There will also be further concerns over the US budget position and risks of a medium-term ratings downgrade, especially with the debt ceiling issue still unresolved. The dollar will gain support at times from deteriorating risk appetite and a reduced flow of funds into emerging markets would also help underpin the currency.

The dollar advanced at times during the week, but found it difficult to gain any significant traction and ended slightly weaker for the period as a whole. The currency was unable to gain support when risk appetite deteriorated on Middle East fears.

The US economic release were also slightly below expectations over the first half as retail sales rose a headline 0.3% for January., but the New York manufacturing PMI index did strengthen to 15.4 from 11.9. The industrial data was also significantly weaker than expected with a 0.1% output decline for January compared with expectations of a 0.5% monthly increase.

The housing data was mixed as a larger than expected increase in starts was offset by a decline in permits to an annual rate of 0.56mn from 0.63mn the previous month. Persistent vulnerability in the housing sector was illustrated by the NAHB housing index remaining at 16, substantially below the long-term equilibrium level of 50.

The Federal Reserve FOMC minutes confirmed the statement that the Fed was more optimistic over the economic outlook, but there were also further references to unemployment being too high and there were still no indications that the Fed would move towards a tighter policy.

The US data later in the week recorded an increase in jobless claims to 410,000 in the latest week from a revised 385,000 previously, but the Philadelphia Fed index rose strongly to 35.9 for February from 19.3. The consumer prices data was slightly stronger than expected with a 0.4% headline increase while core prices rose 0.2%.

The inflation data will give some ammunition to the Fed members looking for an early end to further quantitative easing, but there will still be expectations that a majority of the FOMC will remain committed to the current policy.

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Overall confidence in the EU structural position will remain weak with bond yields too high to allow peripheral countries to service debt and find an escape route from recession.  There will be expectations that Portugal will also require external support within the next few weeks. Fears will certainly subside at times and overall growth rates should be solid given the lead from Germany.  The Euro will still find it difficult to gain strong support given the medium-term vulnerability and any renewed fears surrounding the banking sector would also be an important negative factor for the currency. 

The Euro tested support levels below 1.3450 against the dollar during the week, but resisted further selling pressure and rallied back to the 1.36 area.

The Euro-zone data was slightly weaker than expected with fourth-quarter GDP estimated at 0.3% compared with expectations of 0.4% and there was a further sharp contraction in the Greek economy which will remind markets that peripheral economies remain trapped within recession conditions. The German ZEW business confidence survey edged higher to 15.7 for February from 15.4, but this was weaker than expected.

There was no further progress surrounding strengthening the Euro-zone crisis mechanisms at Tuesday’s ECOFIN meeting and there were further fears that Portugal will be left exposed to renewed funding pressures and require a bailout as benchmark yields remained above the 7.00% level. There was some relief as a restructuring agreement for WestLB was agreed just ahead of the deadline.

There was further speculation that Portugal would need Euro-zone support within the next few weeks and there was also a sharp increase in emergency lending from the ECB over the past two days. The impact will be limited if this is a temporary event, but the Euro could be much more vulnerable if there is a sustained increase in borrowing from the ECB as it would increase banking-sector fears.

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Yield trends will continue to be watched closely and the yen will be vulnerable from the rise in US yields. There will be yen support from capital repatriation over the next few weeks ahead of the fiscal year-end and there will also be exporter selling to take advantage of any yen weakness.  From a medium-term perspective, overall confidence in the Japanese fundamentals is likely to remain weak as the rising debt burden continues to sap confidence. In this context, the yen is likely to secure only short-lived support.

The dollar found support close to 82.20 against the yen during the week and advanced to an 8-week high near 83.90 before correcting slightly lower. The yen was generally weaker on the crosses with Sterling at a six-month high.

The US currency was unable to make a further attack on the 84 level against the yen late in the week and dipped to lows near 83.20 during the US session. There was a decline in US yields which had a negative impact on the dollar although technical factors were a key influence.

As expected, the Bank of Japan left interest rates on hold in the 0.00 – 0.10% range following the latest council meeting. The bank also raised its economic assessment for the first time since May and there will be some cautious optimism that the Japanese economic performance will improve. There were indications that the Finance Ministry is concerned over the risk of further credit-rating downgrades

Sterling:

Monetary policy will remain an extremely important focus and, given the rise in inflation, there will be further expectations that the Bank of England will move to increase interest rates during the second quarter. Higher yields will offer some Sterling support, but there will also be further fears surrounding the economy, especially as any increase in interest rates would weaken confidence at a time when fiscal tightening is starting to have a significant impact.  Overall confidence in the UK economy will remain weak and Sterling’s best defence still comes from a lack of confidence in the other major economies.

Sterling found support on dips to below 1.60 against the dollar and pushed higher to test resistance levels just above 1.62 late in the week in volatile trading. Sterling also advanced to highs beyond 0.84 against the Euro.

The latest UK consumer inflation data was broadly in line with expectations as the headline rate rose to 4.0% from 3.7% and there was a core rate of 3.0%. There had been some speculation over an even higher rate and Sterling retreated following the data release. The unemployment data was also slightly weaker than expected.

Bank of England Governor King was forced to issue a letter of explanation over the high inflation rate and he pointed to further upside inflation risks in the short-term. He also stated that there was a very high degree of uncertainty over the outlook and that there were important splits within the MPC. 

In its quarterly report with the Bank of England raising its inflation forecasts at the same time as the GDP growth forecasts were lowered. Governor King was very anxious to emphasize that the bank does not endorse market interest rate expectations and he also cautioned that the pace of monetary tightening is liable to be slower than anticipated by markets. King’s comments had a substantial impact with Sterling weakening sharply on a scaling back of 2011 rate increases even though the report still suggested that rates would be increased.

MPC member Sentence maintained his call for policy tightening with comments that a series of interest rate increases were required to bring inflation back under control and keep expectations under control. The February MPC minutes will be watched very closely next week to see how close the Bank of England was to raising rates and to assess the potential timing of any future increase.

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There will be further domestic concerns over the impact of franc strength and the National Bank will be in a very difficult position if there are renewed fears surrounding deflationary pressures within the economy. There will be pressure to resist any renewed gains for the franc despite major reservations over an intervention policy. The franc will continue to be strongly influenced by trends in risk appetite and there will certainly be support at times when risk conditions deteriorate, especially if there are renewed Euro-zone area fears.

The dollar hit a high near 0.9770 against the franc, but it was unable to sustain the gains and weakened sharply to test support below 0.95.

After initial gains, the Euro also weakened to a low close to 1.29 against the Swiss currency as there was a fresh spike in fears over the Middle East situation and persistent doubts surrounding the Euro-zone. Safe-haven considerations will remain very important for the franc.

Domestically, the ZEW business confidence indicator improved slightly to -17.2 from -18.4 previously, but there will still be unease over the competitive situation.

Australian dollar:

The Australian dollar found support on retreats back to below parity against the US dollar and advanced to weekly highs above 1.01 during Thursday as the US currency was subjected to wider selling pressure.

The domestic influences were relatively limited during the week with further evidence that the Reserve Bank would leave interest rates on hold in the short-term.

There are likely to be significant reservations over the domestic and international outlook which will make it difficult for the  Australian dollar to reach new highs.

Canadian dollar:

The Canadian dollar quickly found support on corrective retreats during the week and strengthened to test support beyond 0.9850 against the US dollar.

The currency continued to gain some support from the stronger than expected trade data released at the end of last week and there was also further support from the strength of oil prices. In this context, the currency was resilient even when Middle East tensions hampered risk appetite.

The Canadian dollar will find it difficult to advance on valuation grounds and there will be the risk of further protests by the Bank of Canada.

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The rupee found solid support during the week and was able to advance to 1-month highs close to 45.20 against the US dollar. Risk appetite held broadly firm with the US currency also struggling to gain any wider momentum.

There was relief over a rally in the stock market which lessened the immediate risk of further overseas capital flows and a slowdown in the rate of food inflation also provided some degree of relief.

The rupee will find it difficult to make strong gains, especially as emerging-market sentiment is likely to be generally fragile in the short-term.

Hong Kong dollar:

The Hong Kong dollar found support weaker than 7.7950 against the US dollar during the week and strengthened to highs near 7.7850.

The local currency drew support from a generally firmer Chinese yuan and risk appetite also held firm which helped underpin the currency. There was still uncertainty over rends in the property sector which curbed buying support.

The Hong Kong dollar will retreat when international risk appetite deteriorates, but sustained pressure looks unlikely unless there are major Chinese stresses.

Chinese yuan:

Following the spike weaker in the official rate ahead of the Lunar New-Year holiday, the central bank encouraged a firmer currency trend during this week with a record high fixing close to 6.578 against the dollar on Friday.

Central bank Governor Zhou stated that the yuan policy would be determined by domestic influences and not external pressure, but there was speculation that China was looking to let the yuan rise ahead of the G20 meetings.

The latest consumer inflation rate was held to 4.9% compared with expectations of a figure above 5.0% which provided some relief. There was still a high degree of uncertainty over inflation and speculation that further measures would be required to control inflation and property price increases.

Uncertainty over inflation trends and the policy response is still likely to increase in the short-term. The central bank is likely to encourage gradual appreciation for now, but it may become increasingly difficult to maintain stability.

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