Weekly Forex Currency Review 21-01-2011

Global monetary policies will remain an important focus in the short term. There will be increased speculation over interest rate increases outside the US as inflation fears increase. There will also be fears that any monetary tightening could be reversed quickly given that a combination of weak demand and restricted credit supply could trigger a fresh economic slowdown, especially within Europe.           

 Key events for the forthcoming week

Market analysis

Dollar: 

There will be expectations of solid US growth over the next few months, but there will still be doubts whether the recovery will be strong enough to secure a substantial decline in unemployment and, given the Fed’s focus on employment, there will also be doubts whether interest rates will be increased. The Fed’s policies will maintain the risk of dollar selling pressure, especially if interest rates increase elsewhere in the G7 area. Tighter conditions would, however, also increase fears over a renewed global downturn which would tend to support the dollar on defensive grounds. Volatile market conditions will be a high risk and the US currency will find it difficult to gain strong support.

The dollar retreated to two-month lows on a trade-weighted basis in the middle of the week. The US currency did secure a technical recovery, although it was unable to secure a significant recovery against the Euro.

As far as the economic data is concerned, there was a weaker than expected 4.3% decline in annualised housing starts offset by a strong rise in building permits to the highest level for more than 12 months. The data later in the week was stronger than expected as jobless claims dipped sharply to 404,000 in the latest week from 441,000 previously. There was also a sharp rise in existing home sales to an annual rate of 5.28mn from 4.70mn previously while the Philadelphia Fed index held firm at 19.3 for January. The data overall boosted confidence in the US growth outlook.

Ahead of the Federal Reserve meeting next week, there will still be expectations of a sustained ultra-low interest rate policy and the suspicion that the Fed will lag behind other countries will curb dollar support, especially as global yields have been rising.

There is likely to be a greater focus on the US fiscal position in the short term, both at a Federal and State level and further speculation that the key AAA credit rating will eventually come under serious threat.

The latest US capital account data recorded net long-term inflows of US$85.1bn for November from a revised US$28.9bn the previous month and this should provide some degree of support to the dollar with optimism over underlying investment flows.

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Fears over the Euro-zone structural vulnerabilities have eased for now, especially as funding pressures have been contained. The underlying stresses and solvency threat remains very important and there are also very important political divisions, especially within Germany. In this environment, there is a high risk that tensions will rise rapidly again with a particular focus likely on Spain.  The Euro will, therefore, remain vulnerable to renewed pressure and the possibility of higher interest rates will also increase fears over a deeper recession in the vulnerable peripheral economies.

The Euro secured a firm tone during the week with gains against all major currencies as immediate fears surrounding the structural vulnerabilities eased and a move to 8-week highs around 1.3550 against the dollar.

The German economic data remained impressive with the ZEW business confidence index rising further than expected to 15.4 for January from 4.3. The data will reinforce market speculation that the ECB will take greater note of inflation concerns, although the language from council member Weber was not overly hawkish.

There was still a high degree of uncertainty over the Euro-zone capital markets, especially with contradictory remarks from German government officials. There were reports that the government would seek to restructure Greek debt, but these reports were later denied. It is clear that there are very important divisions within Germany and throughout the Euro area. Without a clear policy, there will be a high risk that the current relative calm over debt and solvency issues will not be sustained.

There is also a high risk of further sovereign credit-rating downgrades within the next few weeks which would tend to undermine Euro confidence.

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There has been a slight improvement in the economic indicators, but overall confidence in the Japanese economy will remain weak which will continue to limit the scope for yen support. Risk conditions will remain important and the yen will gain some defensive support when confidence in the global economy deteriorates, especially if China is forced to tighten monetary policy substantially further.  Exporters will also look to sell dollars on any notable rally. Overall, there is scope for dollar gains, but yen losses are still likely to be measured.

The yen strengthened in the middle of the week and pushed to a high just beyond 82 against the US currency, but it was unable to sustain the gains.

The latest monthly Tankan business confidence survey recorded a further improvement which will offer some reassurance over near-term Japanese growth prospects. The Finance Ministry will still be opposed to yen strength and there is a heightened risk of verbal intervention if the currency advances further.

The better than expected US economic data was important in boosting yield support for the US currency and there were further reports of semi-official dollar buying by Japanese institutions.

There was evidence of exporter selling close to the 83 level which slowed the dollar’s advance and there will still be unease over the US fiscal position which will tend to limit buying support. Speculation that further Chinese monetary tightening will be required will also tend to curb selling pressure on the yen.

Sterling:

Inflation will be a very important short-term focus and there will be strong pressure on the Bank of England to raise interest rates in order to keep inflation expectations under control.  The central bank will certainly face a tough task as there will also be fears that the economy will slow sharply.  Given these doubts, near-term expectations of higher rates will not necessarily provide much currency support. It is also the case that there will be some unease over the UK banking sector given its exposure to UK and European bad debts.  Volatility is likely to be high and the currency will find it difficult to gain strong support.  

Sterling volatility remained high over the week as it was buffeted by domestic and international factors. There were reports of heavy Euro buying against the UK currency as the Euro rose to the 0.85 level and this was important in pushing Sterling to a low near 1.58 against the dollar from a 2-month high above 1.60. Sterling had been seen as a safe-haven when Euro-zone fears intensified and there has been some reallocation of funds back to the Euro area as immediate fears have eased.

The headline consumer inflation rate rose to 3.7% for December from 3.3% the previous month. This was the highest reading for 8 months and there will certainly be fears that inflation will rise further given recent tax increases. The inflation rise increased pressure on the Bank of England to tighten monetary policy. There was a substantial move in futures prices following the data with markets pricing in 3 interest rate increases to 1.25% before the end of 2011.

The headline UK labour-market data was slightly better than expected with a small decline in claims for December. The unemployment rate was unchanged and the employment data suggested that conditions were generally weak which curbed Sterling support. The latest Nationwide consumer confidence index recovered from the sharp fall registered last month with a gain to 53 from 45. 

The latest CBI industrial survey was weaker than expected with a decline to -16 for December from -3 previously. As well as weaker order books, the survey also reported rising inflationary pressure which highlights the policy dilemma faced by the Bank of England. Sterling will be vulnerable to selling pressure if there is evidence that the central bank feels that economic weakness will prevent higher interest rates.

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There will be a sharp decline in defensive franc demand if there is a sustained improvement in Euro-zone confidence. There will be further domestic alarm over the impact of franc strength, but the National Bank will be reluctant to intervene again and it will tend to remain a hostage to developments within the Euro-zone as a whole.  The franc will gain support if there is a wider deterioration in international risk appetite and the currency should be able to resist heavy losses with high volatility remaining an important market feature.

There was an increase in Swiss franc volatility during the week as currency policies remained an important market focus. There was a generally weaker tone against the Euro with a retreat to beyond 1.30 while the dollar also recovered from intra-week lows near 0.95. Defensive support for the Swiss franc was generally weaker as immediate Euro-zone fears subsided.

The government held a press conference on the Swiss currency which increased market speculation over fresh action to weaken the currency. The main focus was on additional support for hard-pressed sectors such as tourism and the government reiterated that the National Bank had sole responsibility for franc policy.

National Bank Head Hildebrand stated that franc strength was hurting exports and the recovery. Nevertheless, he also stated that deflation threat had disappeared which suggests that the bank will not have a mandate to intervene and weaken the franc.

Australian dollar:

The Australian dollar found support on retreats to the 0.98 area against the US dollar and rallied back above parity before encountering fresh selling pressure. There was some easing of fears surrounding the flooding which helped support the currency.

This optimism was not sustained as there were renewed fears that China would need to tighten monetary policy more aggressively in order to combat inflation. There was also a generally weaker tone on global stock markets which undermined the currency.  The domestic data did not have a major impact with a decline in consumer sentiment.

Australian dollar volatility is liable to remain relatively high given the potential for sharp fluctuations in domestic and international sentiment. Expectations of further Chinese tightening will tend to limit the scope for Australian dollar rallies.

Canadian dollar:

The Canadian dollar strengthened to re-test resistance near 0.9850 against the US dollar before retreating back to the parity area.

As expected, the Bank of Canada left interest rates on hold at 1.0% following the latest council meeting. The bank statement was more dovish than expected with a focus on the difficulties posed by a strong currency and that Canadian dollar strength would also curb any inflationary pressures. In this environment, there were reduced expectations  of  monetary tightening which undermined the Canadian dollar.

Although oil prices remained high, risk appetite was also generally fragile which had a negative impact on the Canadian dollar, especially as gold prices fell.

It will remain difficult for the Canadian dollar to sustain moves much beyond parity even though a lack of US dollar conviction will help it maintain a firm tone.

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The rupee remained under pressure for much of the week and it retreated to a 7-week low beyond 45.65 against the US dollar. Although losses were generally measured, the move was significant, especially as the US currency was weaker against the Euro.

There were further losses in the local stock market which undermined the currency, especially as there was evidence of foreign withdrawals from the market. International risk appetite was generally weaker which had a negative impact and there were also continuing fears that the central bank would need to respond to higher inflation with a further increase in interest rates this month.

The rupee should be able to resist substantial losses, but there is scope for some depreciation on concerns over the fundamentals, especially if inflation rises further.  

Hong Kong dollar:

The Hong Kong dollar was unable to strengthen through the 7.7750 area against the US dollar and retreated to near 7.7850, equalling lows seen late in 2010.

Underlying risk appetite generally deteriorated during the week which undermined support for the Hong Kong dollar. There was also further uncertainty over Chinese economic policies, especially with fears that underlying inflation was rising.

The Hong Kong dollar will lose ground when international risk appetite deteriorates, but substantial losses look unlikely at this stage.

Chinese yuan:

The yuan gradually strengthened over the week and pushed to a high beyond 6.59 as the central bank continued to encourage gradual appreciation. US officials continued to pressure for a stronger yuan during a US visit by Chinese President Hu, but there were no substantive comments on the subject by Chinese officials.

The official Chinese inflation rate retreated to 4.6% for December from 5.1% the previous month, but there the evidence suggested that credit growth and inflationary pressures were still high and there were expectations that further interest rate increases would be required during the first half of 2011.

The political and economic pressures of rising inflation still suggest that the yuan will gradually strengthen against the dollar in the short term.

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