Weekly Forex Currency Review 20-05-2011

Overall strategy: Conditions within the US and global economy will be watched very closely in the short-term. Although signs of weakening US demand would lessen any possibility of higher US interest rates, the net trend could still be positive for the dollar as there would be a further flow of funds out of emerging-market and commodity-related assets which would tend to support the US currency.   

Key events for the forthcoming week 

Market analysis

Dollar:

The recent data will increase fears that the economy is losing momentum, especially with a significant drop in business confidence. In this environment, there will be expectations that the Federal Reserve will maintain a loose monetary policy over the next few months even if the quantitative easing ends on schedule. The currency will also be extremely vulnerable to further selling pressure if there are any hints over any further quantitative easing.  The dollar will still be supported by a lack of confidence in other major economies and there will be additional backing if there is any further deterioration in confidence surrounding the global economy, especially as there would be a further closing of long commodity positions.

The dollar lost momentum during the week as it was subjected to a technical correction and it also found it more difficult to gain support on position adjustment and the Euro recovered to the 1.43 region.

The US economic data was weaker than expected as housing starts fell to an annual rate of 0.52mn for April from a revised 0.59mn previously while permits also dipped. There was no change in industrial production for the month while capacity use fell.

Jobless claims data was slightly better than expected with a decline to 409,000 in the latest week from 438,000 previously. In contrast, there was a weaker than expected reading for existing home sales with a decline to 5.05mn for April from a revised 5.09mn previously and leading indicators declined. The biggest surprise was the Philadelphia Fed index which retreated sharply to 3.9 for May from 18.5 previously and there was a particularly negative reading for new orders.

Minutes from April’s FOMC meeting reported that there was an intense discussion surrounding exit strategies from the Fed’s quantitative easing programme. There was agreement that the first step should be to let mortgage-backed securities mature without re-investing the proceeds and a similar course would then be taken with Treasuries to gradually shrink the Fed’s balance sheet. There were disagreements over the timing of any potential tightening.

Governor Dudley made generally dovish remarks and core FOMC members will remain opposed to any tightening. The US currency will still gain support for now from the anticipated end of quantitative easing in June, but any suggestion that further action will be required would be extremely destabilising for the dollar.

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The Euro-zone structural difficulties will remain an extremely important short-term focus, especially as sovereign-debt risks will persist. The Greek debt situation remains unsustainable, but suggestions of a soft restructuring will face strong opposition, especially within the ECB and would also increase fears over the European banking sector. There will also be fears that there will be no short-term solution to the situation.  There will be Euro support on expectations that the ECB will maintain a firm policy tone and look for a further increase in interest rates. The Euro will still find it difficult to make much headway as it remains over-valued on a medium-term perspective.

Selling pressure on the Euro eased during the week, although it was still generally fragile given underlying uncertainties.

There was further unease surrounding the Greek debt situation following reports the previous day that some form of soft restructuring would eventually be required. There were fresh warnings over the threat posed by any debt restructuring with ECB member Bini-Smaghi, for example, warning that such a move could devastate the Greek banking sector. There were also wider fears surrounding the European banking sector and there is little chance of early relief as EU governments will not be able to address the situation until the IMF report on Greece is prepared which appears unlikely until the second week of June.

There were further underlying stresses later in the week as the ECB made more forceful remarks surrounding the Greek situation. The central bank remains strongly opposed to any form of restructuring and also warned that Greek bonds would not be accepted as collateral.

Markets will remain in limbo until the IMF releases its interim report on the Greek economy and this will remain a negative influence on the Euro. There was support on yield grounds as there was still speculation that inflation fears would trigger further ECB action on interest rates.

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Overall confidence in the economy and fundamentals will remain extremely fragile, especially as the government-debt situation remains extremely dangerous.  Although there were no fresh measures, the Bank of Japan will maintain an extremely loose monetary policy to support demand which will tend to hurt the yen. Global risk considerations will still have an important impact and the yen will gain support when there is a sharp deterioration in confidence. Nevertheless, the yen will find it difficult to sustain gains given underlying vulnerability and net capital outflows.

The dollar found support on retreats to just below 81 against the yen with a generally weaker yen tone on speculation over merger-related flows out of Japan.

There was still little in the way of enthusiasm for the Japanese economy with sentiment undermined by comments from Bank of Japan Governor Shirakawa that the economy was in a severe state following the earthquake. The economic data reinforced growth fears with a 6.0% monthly decline in the services sector for March and a further sharp GDP contraction for the first quarter.

The US currency retreated following weaker than expected economic data with a retreat to the 81.50 area as US Treasury yields declined on fears over weaker economic activity.

Confidence in the Japanese economy remained very weak and there were strong expectations that the Bank of Japan would maintain a highly-expansionary monetary policy at its latest policy meeting. The central bank held interest rates in the 0.00-0.10% range at the council meeting and decided not to provided any additional stimulus at this time.

Sterling:

The most recent economic data has been mixed with some distortions from seasonal influences, but underlying confidence has remained weak with further concerns that employment fears and weak disposable income will undermine the economy.  Despite inflation fears, the Bank of England will find it very difficult o increase interest rates significantly, especially given persistent banking-sector fears and the lack of yield support will tend to undermine Sterling. There will still be protection from alack of confidence in other major currencies unless there is a fresh deterioration in the banking sector.

 The latest UK consumer inflation data was much stronger than expected with the headline rate increasing to a three-year high of 4.5% for April from 4.0% previously and compared with expectations of a 4.2% rate. The core rate also increased to 3.7% for the month and Sterling spiked higher following the release with a peak just above 1.63 against the dollar, but Sterling was generally fragile.

Bank of England Governor King was forced to write another letter to explain why the inflation rate remained outside a 1-3% range and King maintained that the rate was liable to increase further in the near term. He also stated that it would be a mistake to seek to bring inflation down too quickly as this would risk triggering a substantial deterioration in economic conditions.

There was a larger than expected increase in the jobless claimant count of over 12,000 for April, although the ILO unemployment rate actually declined. The data overall maintained unease over the level of demand within the economy.

The Bank of England minutes recorded a further 6-3 vote in favour of unchanged interest rates at the May meeting. Sentence continued to his campaign for a 0.5% increase with Weale and Dale also calling for rates to be increased by 0.25%.  

The headline retail sales data was stronger than expected with an increase of 1.1% for April compared with a consensus forecast of a 0.8% gain. There was also an encouraging CBI manufacturing survey. Nevertheless, underlying confidence in the economy remained weak with expectations that the rebound in spending would not be sustained given the underlying downward pressure on real incomes.

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International considerations will continue to dominate in the short-term. The Swiss currency will remain the ultimate safe-haven currency, especially with all major alternatives suffering from a lack of confidence. Any deterioration in confidence surrounding the Euro-zone banking sector would also boost the Swiss currency.  There will be fears surrounding the Swiss economy after a deterioration in business confidence and there will be pressure for action to curb fresh appreciation. The net risks still suggest that heavy franc selling is unlikely.

The dollar peaked above 0.89 against the Swiss currency during the week and retreated to lows just below 0.88 in choppy trading.

The Euro was unable to find support close to 1.25 against the franc and recovered to above 1.36, but it remained dogged by fears surrounding the Greek debt situation and wider sovereign-debt risk. There was wider safe-haven related franc demand as confidence in other major currencies remained weak.

The latest ZEW business sentiment index was weaker than expected with a slide to -11.5 from 8.8 previously which will increase fears that franc strength is now starting to hurt the economy. The Swiss Finance Minister also expressed concerns over the strong-franc trend.

Australian dollar:

The Australian dollar found support in the 1.05 region against the US currency during the week and recovered back to the 1.0650 area, although it did tend to under-perform on the crosses. Despite daily volatility, there was a general stabilisation in risk appetite which helped curb selling pressure on the currency.

The Reserve Bank minutes suggested that interest rates would need to rise again over the next few months, but the domestic data did not back this up with a further decline in home-loans. There were also credit-rating downgrades for the main Australian banks which also undermined sentiment

There will continue to be strong-buying support for the Australian dollar on retreats, but the net trend is liable to be for a further correction weaker against the US dollar.

Canadian dollar:

The Canadian dollar found support on retreats toward 0.98 against the US currency during the week and consolidated in a 0.9650-0.97 range as the US currency lost momentum.

There were no major domestic economic releases during the week and trends in commodity prices tended to dominate with the Canadian currency gaining some relief as oil prices looked to rally from steep losses.

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

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The rupee remained under some selling pressure early in the week and retreated to 2-month lows near 45.20 before finding support and consolidating in the 45.0 area.

The currency was unsettled initially by a wider deterioration in risk appetite and the rupee also found it difficult to recover ground with unease over the risk of longer-term capital outflows. There was some relief over the latest inflation data and a more fragile US currency tone also provided protection for the currency.

The rupee should be able to avoid heavy losses even though it will be difficult for the currency to make strong headway given doubts over capital flows.

Hong Kong dollar:

The Hong Kong dollar retreated to lows near 7.7780 against the US currency early in the week before gradually recovering to the 7.7730 area. The US currency had a slightly softer tone which provided some support and there was optimism surrounding IPO-related inflows.

From a longer-term perspective,, there was some unease over the increase in yuan-denominated bank deposits with the HKMA looking to curb growth in deposits

The Hong Kong dollar should be able to resist strong selling pressure, but there will be increased speculation over the currency’s future with potentially higher volatility.

Chinese yuan:

The yuan dipped weaker during the middle of the week with a retreat to near 6.51 against the US currency. There was a recovery later in the week with the currency strengthening back through the 6.50 level as the US currency had a softer tone.

There was a pledge from the central bank that the yuan would be made more convertible over time, but with no indication of substantive near-term moves.

There is still the potential for gradual short-term yuan appreciation, although any serious doubts over Chinese growth trends could spark a sharp reversal late in 2011.