Weekly Forex Currency Review 03-08-2007

Risk tolerances and the extent of credit fears will remain very important in the short-term. There will continue to be active buying of high-yield currencies on any significant retreat, but the underlying market stance is likely to be more defensive as global liquidity conditions tighten. The US dollar has the potential to secure defensive capital inflows, but is unlikely to make strong headway given the US economic doubts. 

Key events for the forthcoming week

Dollar

The US economic concerns will continue to unsettle the dollar in the short-term with fears that the wider economy will be damaged by mortgage-related stresses. The markets are already close to pricing in a Federal Reserve interest rate cut by the end of 2007 and this will offer some dollar protection unless forthcoming data is especially weak. A strong payroll report would also boost confidence. The net impact of increased risk aversion is liable to be slightly dollar positive on repatriation flows, but strong gains are unlikely given the US structural weaknesses.  
      
The dollar came under pressure against the low-yield currencies during the first half of the week, but managed to regain ground over the second half. The US currency was unable to make any strong impression against the Euro and settled close to 1.37.

US currency moves were dominated for much of the week by risk aversion levels, carry trades and Wall Street with the dollar gaining initial support from a more defensive investor stance. As risk aversion eased slightly the dollar drifted weaker against the Euro with a reduced flow of capital back to the US.

The ISM manufacturing index was weaker than expected with a decline to 53.7 in July from 56.0 the previous month, although the overall components were still firm.

The ADP employment report was weaker than expected with the increase in jobs limited to 48,000 which triggered a downgrading of expectations for the monthly employment report. Consumer confidence recovered to the highest level since 2001.

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Comments from the ECB continue to suggest strongly that the bank will aim for an increase in interest rates at the September meeting. The firm monetary stance will provide underlying Euro protection, but is unlikely to trigger firm buying support. The economic data has remained relatively firm, but there will be the risk of deterioration, notably in the property sector. The Euro is unlikely to see strong selling pressure unless there is clear evidence that interest rates have peaked or there are clear signs of substantial deterioration in growth prospects.            

The Euro was subjected to high volatility against the yen and Swiss franc and managed to recover from heavy losses in mid week. The Euro was unsettled to some extent by reports of German banking-sector losses involving sub-prime mortgages.

The ECB left interest rates on hold following the latest council meeting with the main repo rate held at 4.00%.

In a press conference following the decision, ECB President Trichet stated that strong vigilance would be required on inflation and this suggested that the bank would look for a further interest rate increase to 4.25% at the September council meeting.

There were no major Euro-zone data releases during the week, although a 45,000 drop in German unemployment reinforced near-term confidence in the economy.

Yen  

The Bank of Japan will consider an interest rate increase at the August meeting and failure to tighten would weaken the currency slightly. The yen will continue to be influenced strongly by carry trades and the net risks suggest that there will be grater caution. The tightening of global liquidity will also tend to curb yen selling and there will be the risk of forced position closure on margin calls. There will still be interest in selling the yen on rallies and institutional dollar buying is likely to increase if there are sharp Japanese currency gains. Nevertheless, the yen is likely to secure overall appreciation on continuing volatility.            
                    
The yen strengthened temporarily to highs beyond 118.0 against the dollar and to near 160.0 against the Euro during the week, but was unable to sustain the gains.

There were reports of institutional dollar buying when the yen strengthened through the 118.0 level against the US currency. There was also persistent retail interest in selling the yen on rallies as individuals continued to target high-yield currencies.

There was little in the way of domestic economic data with levels of risk aversion and carry trades tending to dominate the yen, although unemployment did fall to 3.7% in June from 3.8%.

The latest capital account figures suggested some capital repatriation back to Japanese markets, but also a reduction in investment flows into Japan.

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The Bank of England will maintain a tightening policy bias, especially with persistent inflation concerns. The bank will probably not be as aggressive as the market is expecting which will curb Sterling buying and there is also a risk that growth will deteriorate with particular risks surrounding the consumer sector. Sterling will also be strongly influenced by developments in carry trades and markets are likely to be more cautious over high-yield currencies. Overall, the UK currency is liable to weaken over the next few weeks as a whole.           
 
Sterling weakened to lows around 2.02 against the dollar, but was bale to regain composure later in the week with a move back to highs around 2.0370. The UK currency also recovered losses against the yen after a very sharp retreat to a seven-week low.

Sterling moves were influenced strongly by carry trade developments during the week as volatility levels remained high. The UK currency came under selling pressure when stock markets fell as there was a move out of high-yield currencies.

The Bank of England left interest rates unchanged at 5.75% following the latest MPC meeting and released no statement.

The CIPS manufacturing  index was stronger than expected with an increase to near a three-year high at 55.7 while the prices index in the survey was also strong.

There was mixed evidence on the housing sector while the survey evidence suggested a gradual slowdown in consumer spending as confidence weakened.

Swiss franc

The Swiss economic trends are likely to remain favourable in the short-term with firm growth and the potential for further interest rate increases. Global risk conditions will tend to dominate in the short-term and the switch into more defensive currencies will tend to support the franc. A further increase in risk aversion could trigger forced position closure and rapid franc gains and volatility levels are likely to remain higher.
 
The Swiss currency gained strongly to 1.6350 against the Euro in the middle of the week before weakening back to 1.6520. The franc was also unable to hold gains stronger than 1.20 against the dollar.

The franc gained support from increased levels of risk aversion during the week, especially when fears over sub-prime related losses spread to Euro-zone markets. A recovery in stock markets reduced franc demand later in the week

The growth data remained strong with the July PMI index strengthening to 63.0 in July from 62.8 the previous month

The inflation data recorded a 0.6% drop in consumer prices for July, but the annual inflation rate edged higher to 0.7% from 0.6% as prices also fell sharply in July 2006.

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The Australian dollar fell sharply to lows below the 0.85 level against the dollar before secured a tentative recovery back towards 0.86 in volatile trading. The Australian currency moves were linked strongly to global interest in carry trades and the degree of confidence in global stock markets.

The retail sales data was strong with a 1.4% monthly increase for June.  There were also strong readings for building approvals and credit growth. The firm data increased expectations that the Reserve Bank would increase interest rates again to 6.50% in August.

The trade deficit increased sharply to AUD1.75bn for June as unfavourable weather conditions undermined export shipments, although there was also evidence of a slowdown in underlying export growth.

Yield considerations will protect the currency, but it will be difficult to regain momentum in the short-term and the underlying tightening of credit conditions will limit the scope for renewed gains. 

Canadian dollar

Canadian volatility remained generally high over the week. The local currency dipped to lows around 1.07 against the US dollar before a recovery back to near 1.0550. There was little in the way of economic data during the week to influences the Canadian dollar

The Canadian currency drew support from the high level of oil prices with crude trading close to record highs while merger-related capital inflows continued.

The Canadian dollar was influenced by carry trades with the currency weakening when the yen strengthened as funds moved out of Canadian currency. A recovery in risk appetite helped support the Canadian dollar later in the week.

Confidence in the economy should underpin the Canadian dollar, but there is likely to be tough resistance below the 1.05 level, especially with greater reservations over carry trades.

Indian rupee

The Indian rupee has traded within relatively narrow ranges during the week despite an underlying increase in market volatility. The rupee has generally been able to hold close to the 40.50 level against the US dollar and edged stronger to 40.38 on Friday.

The rupee dropped on Wednesday as the local stock market fell by 4.0%, but the currency still proved to be resilient with continuing underlying investment inflows.

The central bank left interest rates unchanged at the last meeting, but increased the cash reserve requirements and this tended to put upward pressure on local money market rates which underpinned the rupee.

The Indian currency was still unsettled by the high level of oil prices while fears over central bank intervention also curbed gains.

The underlying capital inflows will continue to support the Indian rupee in the short-term, especially if local interest rates increase. Nevertheless, there is the risk of a significant correction weaker given evidence of investor complacency.

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The Hong Kong dollar was generally weaker during the week and tested multi-year lows around the 7.83 level against the US currency on Wednesday before edging back to 7.8280 on Friday.

There were capital outflows from Asian markets following the increase in stock market volatility which curbed Hong Kong currency demand.

There was also evidence of arbitrage activity with the Hong Kong dollar seen as a lower-risk instrument to use as a funding currency for carry trades.

The currency trend is likely to remain dominated by arbitrage activity in the short-term. Overall, the Hong Kong dollar should be able to resist losses much beyond current levels.

Chinese yuan

The Chinese yuan weakened over the week as a whole and settled close to 7.57 against the US dollar on Friday.

The central bank allowed the yuan's reference rate to strengthen on Wednesday but, in general, resisted currency gains during the week by setting the reference rate weaker.

US Treasury Secretary Paulson again called for a faster pace of yuan appreciation during his visit to China. These calls were rejected by Chinese Finance Minister Jin

The yuan gained some support in the middle of the week from yen strength, but markets were generally cautious.

There has been persistent speculation over further measures to tighten Chinese monetary policy and the central bank increased reserve requirements

The underlying trend should be for further yuan gains and there remains the possibility that the authorities will sanction a one-off currency revaluation to help curb inflationary pressure.