Weekly Forex Currency Review 17-08-2007

Overall strategy

The extent of credit-related fears, risk aversion and carry trades will remain extremely important in the short-term. There will be much greater caution towards carry trades and high-yield currencies even with the potential for at least a partial correction after recent very heavy losses. In this environment, the yen and Swiss franc should remain firm. The dollar will find it difficult to extend gains against the Euro given US growth fears.   

Key events for the forthcoming week

Dollar

The dollar will continue to gain short-term backing from a defensive flow of funds into US Treasuries and support will tend to increase if there are sustained emerging-market stresses. There will, however, be further concerns over US economic conditions with growing risks of a downturn in consumer spending and increased fears over a slide towards recession. There will also be further speculation over a near-term Federal Reserve interest rate cut. In this context, the US currency is unlikely to make strong headway against major currencies.    
      
Market volatility increased sharply over the week with the dollar securing net gains despite the large disparity in moves against individual currencies. The dollar pushed to highs beyond 1.34 against the Euro, but with sharp losses against the yen.

The US currency gained strong support from an increase in risk aversion, especially as emerging-market currencies came under heavy pressure over the second half of the week. There was a repatriation of investment to the US while investment positions against the dollar were also scaled back.

The US mortgage sector was severely damaged by fears that Countrywide Financial would be forced into liquidity, while underlying credit conditions continued to tighten which triggered increased margin calls.

The latest construction data recorded a drop in housing starts to 1.38mn for July from 1.47mn while permits also weakened to below the 1.40mn level with a 20% annual decline in both data series.

There was a 0.1% increase in consumer prices for July while there was a 0.2% underlying increase to give a 2.2% annual increase. There was a core 0.2% increase in producer prices for the month.

The trade deficit fell to US$58.1bn in June from a revised US$59.2bn the previous month as exports rose to record levels. Long-term capital inflows remained strong in June at US$120.9bn even though total investment flows were weaker.

The industrial data failed to have a significant impact with a 0.3% production increase for July, but confidence in growth was shaken by a drop in the Philadelphia Fed index to zero for August, the lowest level for the year.

Given the market turmoil, markets moved to price in an interest rate reduction at the September meeting and a full 1% decline to 4.25% by the end of 2007.

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There will be further doubts whether the ECB will be in a position to increase interest rates in September, especially if credit-related stresses intensify and these doubts will damage underlying Euro sentiment. There is also the threat of economic deterioration if property-sector concerns increase and the currency will also be unsettled if there are further banking losses. Overall fundamentals and confidence in the economy should, however, remain firm in relation to other major economies which will limit losses.          

The Euro weakened sharply over the week with a sharp retreat against the dollar and heavy losses against the yen. The Euro weakened to lows near 150.0 against the Japanese currency.

There was little in the way of major  economic data over the week, but the preliminary second-quarter GDP increase was held to 0.3% compared with expectations of 0.5% increase which maintained expectations of slower growth.

The Euro was unsettled by uncertainty surrounding the European financial-sector and fears that further sub-prime related losses would be revealed.

The ECB was forced to add huge amounts of liquidity to the market to keep markets functioning. The chances of a September ECB interest rate increase were cut to below 50% from near 100% two weeks ago

Yen 

There will be reduced speculation over an August interest rate increase, but global financial trends are liable to remain dominant in the short-term. The increase in risk aversion will continue to strengthen the yen in the short-term with a shift away from high-yield currencies. Once carry trades have been scaled back substantially, there will be some scope for a rebound in high-yield currencies and a weaker yen, but volatility levels will remain very high.              
                    
The yen gained sharply during the week from a scaling back of carry trades as credit fears intensified. The Japanese currency pushed to highs around 112.0 against the dollar after the biggest one-day gain since 1998. The yen also gained rapidly against the Euro with a peak beyond 150.0.

The latest data did not suggest heavy capital repatriation, but there was still a net positive flow of capital into Japan.

There was some evidence that retail investors were scaling back overseas bond purchases and closing existing high-yield positions.

There were rumours that the Bank of Japan was checking prices to help stabilise markets, but no evidence of intervention.

The provisional second-quarter GDP increase was held to 0.1%. Markets lowered the probability of an August interest rate increase to around 20%.

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Given the combination of lower inflation and financial-market turbulence, expectations of another interest rates increase will continue to decline which will undermine Sterling.  Capital inflows are also liable to weaken given that flows have been attracted from strong UK financial markets. There are also very high risks associated with the housing sector which will pose serious medium-term risks to the economy and currency. Overall, despite intermittent rallies, further Sterling weakness is realistic over the next few weeks.            
 
Sterling depreciated against the Euro over the week, but the main volatility was against the dollar and yen with the UK currency weakening to a two-month low against the US currency around 1.97 and a six-month low against the yen.

The July UK consumer inflation rate fell sharply with a fall to 1.9% from 2.4% the previous month. The core inflation rate fell to 1.7% from 2.0%.

There was a decline in headline average earnings growth to 3.3% in June from 3.5%. Retail sales recorded a 0.7% increase for July to give annual growth of 4.4%, but retailers were forced to cut prices to maintain volumes.

The Bank of England minutes recorded a 9-0 vote for unchanged interest rates at the August MPC meeting. There was also a calm stance over inflation and no pressure at the meeting for a further near-term interest rate increase.

Markets moved to cut the chances of a further interest rate rise following the market turmoil and inflation fall. Indeed, there was some speculation that the Bank of England would cut interest rates by year-end as market turbulence intensified.

Swiss franc

There are likely to be some doubts over the potential for a September National Bank interest rate increase, but the Swiss economic outlook will still remain favourable. Global credit conditions are likely to remain dominant for now and there will be further safe-haven demand for the Swiss currency even though there has been an underlying drop in demand for European currencies. A repayment of franc-denominated loans would also support the franc. Overall, the Swiss currency is strongly placed to secure net gains over the next few weeks despite intermittent selling pressure. 
 
The Swiss currency strengthened to highs around 1.6220 against the Euro during the week, the highest level since June with notable gains on Friday. The franc also found support close to 1.22 against the dollar.

Increased risk aversion helped support the franc against the Euro and the Swiss currency was securing increased buying support late in the week as wider risk aversion intensified with a major shift into defensive assets.

There was a weaker than expected 1.0% retail sales increase for June, but the increase for the first half of 207 was still 4.9%.

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The Australian dollar suffered very sharp losses over the week with a decline to lows around 0.7700 over the week with a particularly rapid decline on Thursday as global credit conditions deteriorated.

The Australian dollar was undermined by a sharp reduction in carry trades with a flow of funds back to Japan as global stock markets fell sharply. The currency was also undermined by fears over Australian financial-sector losses and lower commodity prices.

Domestic data releases failed to have a significant impact with attention firmly on the global market conditions, although the financing difficulties for Australian companies had a negative impact.

Volatility is liable to remain higher in the short-term with the Australian dollar looking to secure at least a partial correction after recent heavy losses.

Canadian dollar

The Canadian dollar was unable to sustain a brief gain through the 1.05 level against the US currency and weakened sharply to lows around 1.0870 on Thursday.

The Canadian currency was undermined by a reduction in carry trades during the week as there was a sharp reduction in carry trades funded through the yen.

The currency was also undermined by a drop in crude oil prices during the week. Markets were less confident that interest rates would increase, although futures contracts did not move as much as in other major economies.

The degrees of global risk aversion will tend to remain dominant for now. With fundamentals still sound, the Canadian dollar should be able to resist heavy losses.

Indian rupee

Indian rupee volatility has continued to increased as global volatility has intensified. The rupee weakened sharply on Thursday and Friday with lows around 41.55 against the US currency, the weakest level for three months.

The Indian currency was unsettled by heavy falls in global stock markets and tightening credit conditions.

The rupee was more vulnerable this week as emerging-market currencies in general came under pressure. There were net outflows from the Indian stock market which contributed to selling pressure on the local currency.

Exporter dollar selling was running at reduced levels over the week due to less confidence over the underlying currency trend.

Volatility levels are likely to remain higher in the short-term with the net trend likely to be for rupee depreciation despite the potential for a partial corrective recovery.

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The Hong Kong dollar strengthened significantly to highs around 7.80 against the US currency during the week.

Despite a sharp dip in equity prices, there was no evidence of a substantial outflow of capital from the local stock market which helped support the Hong Kong currency.

A global closing of carry trades helped trigger gains for the local currency given that it has been an important funding currency over the past few months. There was reduced interest in arbitrage activity.

The Hong Kong dollar will struggle to secure gains much beyond the 7.80 level against the US currency in the short-term.

Chinese yuan

The Chinese yuan has been generally weaker over the week with the currency weakening to beyond the 7.60 level. The five-day retreat was the largest since the yuan float in 2005. The Chinese authorities were concerned over the impact of market stresses and resisted yuan appreciation.

Speculative capital inflows were also weaker in light of the developing emerging-market stresses and currency losses for emerging Asian currencies.

The consumer inflation data was in line with market rumours with an increase to 5.6% for July which maintained expectations of a further monetary tightening..

Despite near-term volatility, the Chinese currency is still likely to appreciate on a medium-term view, especially with high inflation limiting the scope for any relaxation of monetary policy.