Weekly Forex Currency Review 28-01-2011

09.30 AM GMT Overall strategy:  An important feature in the short - term is that confidence in all the major currencies is liable to be weak with the US, Euro-zone and Japan all unsettled by very important debt concerns. In this environment, it will be the currency which is seen to be the least bad that will tend to gain investor support and there may be some defensive flight to US assets despite the US vulnerability.           

Key events for the forthcoming week

Market analysis

Dollar

Despite some weather-related distortions, the US growth data has been generally favourable which will provide some support for the dollar. There will, however, still be a major stumbling block in the context that the Federal Reserve remains committed to ultra-low interest rates until the employment picture improves.  In this environment, dollar protection will not be a priority. There will also be longer-term unease over the US fundamentals with further speculation that the AAA credit rating will come under threat. There will still be defensive US currency support at times, especially if Euro-zone fears intensify again.

The dollar was generally on the defensive during the week, but did stage a tentative recovery from a 10-week low on a trade-weighted basis as Japan and the UK were hit by domestic fears.

The US consumer confidence data was stronger than expected with a gain to 60.6 for January from a revised 53.3 previously, but the dollar was unable to gain any traction. The Case-Shiller house-price index recorded an annual decline of 1.6% which reminded markets over the fragile housing sector.

Ahead of the State of the Union address, there were strong indications that President Obama would propose a five-year freeze for some discretionary spending and this had some impact in pushing US Treasury yields down which dented dollar support.

Jobless claims rose to 454,000 in the latest week from 403,000 previously while there was a 2.5% decline in durable goods orders. The underlying data was more favourable and the unemployment data was probably distorted by adverse weather conditions. There was also a reported increase in new and pending home sales.

As expected, the Federal Reserve left interest rates on hold in the 0.00-0.25% range following the latest FOMC meeting and, in contrast to 2010 meetings, there was a unanimous vote. The Fed was slightly more optimistic surrounding the economic outlook, but still stated that growth was insufficient to lower unemployment. Interest rates would be maintained at very low levels for an extended period and the overall tone was generally dovish.

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Fears over the Euro-zone structural vulnerabilities have eased for now, especially as there has been reasonable success in the 2011 bond auctions. Underlying confidence will still be very fragile and yield spreads have started to widen again which may be a danger sign. There will also be further speculation that medium-term debt restructuring for countries such as Greece will be unavoidable. The Euro will gain some near-term support from the tougher ECB rhetoric on inflation, although this line may not be sustainable given that higher borrowing costs would put further downward pressure on the weaker economies. Overall, the Euro will find it difficult to extend gains from current levels.

The Euro maintained a strong tone over the week with a fresh 2-month high above 1.3720 against the dollar while it also pushed higher against Sterling and the yen. There was strong demand for the European Financial Stability Fund (EFSF) bonds which helped maintain a more optimistic tone towards the Euro.

There was some relief that the Irish government managed to win a crucial vote on the 2011 budget and immediate fears surrounding the Euro-zone structural vulnerability continued to ease. There are still very important on-going discussions related to debt restructuring within the Euro area, especially for Greece. There are elements within the German coalition government who believe that a restructuring is inevitable and what a quick solution to avoid a more damaging restructuring later. Underlying tensions will remain an important and  potentially negative Euro factor.

Later in the week, the Euro-zone business confidence data was stronger than expected, but the main impetus for Euro support again came from interest rate expectations. ECB President Trichet repeated his comments that the central bank would do whatever was necessary to contain inflationary pressures. Bini-Smaghi warned over the impact of imported inflation, again with a clear warning over the possibility of higher rates.

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The Standard & Poor’s credit-rating downgrade will reinforce market fears over the Japanese fundamentals with fears major fears over the fiscal burden and the changing structural factors will also make it more likely that Japan will be subjected to net capital outflows.  There will also be further Finance Ministry resistance to any yen gains given that deflation fears remain an important influence.  There will still be a lack of confidence in the US and Euro-zone which will tend to protect the yen from substantial short-term capital outflows. In this environment, slow depreciation is a realistic outcome.

The yen was resilient against the dollar over the first half of the week, but then dipped sharply and also lost ground on the major crosses.

As expected, the Bank of Japan left interest rates on hold in the 0.00 – 0.10% range and the central bank also left its economic outlook unchanged. The bank overall suggested that it was slightly more optimistic over the economic outlook, but it will maintain an extremely loose monetary policy.

The latest economic data was mixed as there was a decline in unemployment to 4.9% from 5.1%, but the retail sales and household spending data was sharply weaker than expected with a 3.3% annual spending decline. Services-sector prices fell 1.3% in the year to December and there will be further unease over the threat of deflation and there is, therefore, likely to be further opposition to significant yen appreciation

The yen weakened sharply to lows around 83.20 following a credit-rating downgrade from Standard & Poor’s with the sovereign rating cut to AA- from AA. Confidence in the fiscal position has been gradually deteriorating and underlying confidence will remain weak with the risk of capital outflows.

Sterling

Inflation and growth concerns will continue to be very important areas of focus in the short  -term. With inflation set to rise further, there will certainly be pressure for the Bank of England to raise interest rates, but there will also be fears that economic confidence could deteriorate rapidly on any tightening. Fears over stagflation will tend to increase and this is unlikely to be a positive Sterling influence. External influences will also be important and Sterling will be more vulnerable to selling pressure if risk appetite deteriorates.  A key feature is likely to be high volatility as sentiment fluctuates with net losses a likely outcome.

There was high Sterling volatility during the week with net losses against the Euro while Sterling dipped sharply from highs just above 1.60 against the dollar.

The fourth-quarter UK GDP estimate of -0.5% was substantially weaker than expected and was the first contraction for six quarters. There was a negative impact from adverse weather conditions and the data could be revised, but there was still a very negative impact on Sterling confidence with markets pricing out a rate increase until the third quarter of 2011.

Bank of England Governor King warned against reacting to high short-term inflation even though he warned that the headline rate was likely to increase to 4-5%

In the Bank of England Minutes from January’s meeting, Posen maintained his preference for an expansion of quantitative easing, but Sentance and Weale both voted for an interest rate increase. There was also a general increase in unease surrounding inflation and a rate hike was probably only prevented by the bank’s unwillingness to act in January and shock markets.

The key question for February’s meeting is whether the GDP data and other evidence on the economy will persuade members that an interest rate increase is not needed or whether the inflation fears will maintain pressure for higher rates.

Later in the week, there was another strong reading for the CBI retail sales survey. In contrast, the latest GfK consumer confidence was much weaker than expected with a decline to the lowest reading since March 2009 at -29 from -20 previously.

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Defensive demand for the Swiss currency will diminish when confidence in the Euro-zone outlook improves and there will also be fears that the Swiss economy will be damaged by the recent franc appreciation. There will still be important underlying fears surrounding the Euro and the franc is likely to prove broadly resilient. Any renewed widening in peripheral yield spreads could also trigger a fresh spike stronger for the Swiss currency.

The Swiss currency was unable to make any fresh headway against the Euro, but it was generally resilient. The dollar weakened to 2011 lows just below the 0.94 level before finding some tentative support.

There was an underlying easing of immediate Euro-zone fears and this did have an impact in reducing defensive demand for the Swiss currency.

National Bank Chairman Hildebrand warned over the negative consequences of a strong franc, but there was no suggestion of intervention at this stage.

Australian dollar

The Australian dollar made brief attempts to push above parity against the US currency, but it was unable to sustain the advance and retreated to test support below 0.99 with slightly narrower ranges than in the previous week.

The fourth-quarter inflation data was weaker than expected which dampened speculation over a further Reserve Bank tightening even though prices are likely to spike higher on flood damage. The government announcement of higher taxes to fund reconstruction also had a negative impact on the currency.

Overall risk appetite held up relatively well, but there was some downward pressure on metals prices which also lessened demand for the Australian currency.

There are likely to be reservations over the domestic and international outlook which will curb Australian dollar rallies despite buying interest on any significant dips.

Canadian dollar:

The Canadian dollar had a slightly weaker tone, although ranges were relatively narrow and it consolidated just stronger than parity. The currency lost ground at the end of last week following weaker than expected consumer inflation data with further doubts whether the Bank of Canada would increase interest rates in the near term.

The US commitment to low rates and cautious optimism over US growth trends provided support for the Canadian currency, but there was a weaker tone to commodity prices which curbed buying support

It will remain difficult for the Canadian dollar to sustain moves much beyond parity even though a the persistent lack of US dollar conviction will limit any selling.

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The rupee remained generally on the defensive against the US currency, but it was able to find support stronger than the 46 level as Euro strength helped cushion the Indian currency. There was strong dollar demand from oil importers during the week which tended to undermine the rupee.

The stock market remained an important focus and the main index retreated to a five-month low. With further evidence of overseas selling, this was a negative influence on the local currency, especially as a further increase in the repo rate to 6.50% reinforced expectations that the economy would slow.

The rupee should be able to resist substantial losses, but there is scope for some further depreciation on concerns over the fundamentals and capital outflows.  

Hong Kong dollar

The Hong Kong dollar remained under pressure during the first half of the week and weakened to a fresh 2011 low close to 7.7980 against the US currency. There was a rally in mid week, but it was unable to sustain move through 7.7850.

The currency secured some respite following the generally dovish US Federal Reserve comments, but there was solid US dollar demand with uncertainty over Chinese policies having some negative impact.

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

Chinese yuan

The yuan maintained a generally firm tone against the US currency, but the trend for stronger fixes was interrupted at the end of the week as the central bank pushed the central rate back beyond 6.59 from a post-float peak near 6.58. Trading activity declined late in the week ahead of next week’s New-Year holidays.

During US-China trade negotiations, there were some indications that the rhetoric had change to suggest a faster rate of yuan appreciation, but the central bank reiterated comments that the currency would be kept basically stable.

There were further uncertainties surrounding inflation and the likely central bank response and there were increased fears over an underlying economic over-heating.

The central bank will not want rapid currency appreciation and will want to maintain tight control, but steady yuan appreciation would help ease inflation pressures.

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