Weekly Forex Currency Review 25-05-2007

Overall strategy

The improvement in yield spreads and some greater optimism over the US economy will help support the dollar in the short-term, although underlying confidence is still likely to be fragile which will limit gains. There are still high risks associated with carry trades given the risk that any turbulence in China will have a wider impact in undermining high-yield investments.

Key events for the forthcoming week

Dollar

The economic data this week has maintained greater confidence over the economy, but the major releases at the end of next week will be important in determining whether this optimism can be sustained. The dollar will draw further short-term support from a rise in yields. The US currency will still find it very difficult to make strong headway, especially give the underlying structural weaknesses and risk of central bank diversification away from dollar reserves.    

The dollar was trapped in generally narrow ranges over the week. The US currency found support close to 1.35, but was unable to break the 1.34 level. The trade-weighted index edged slightly stronger.

US durable goods orders recorded a 0.6% increase for April after a 5.0% increase for the March with a 1.5% underlying monthly increase.

Jobless claims rose back above the 300,000 level to 311,000 in the latest week which suggested the underlying labour market conditions are little changed.

New home sales rose strongly in April to an annual rate of 981,000 from 844,000 the previous month. Inventories fell, but there was also a sharp drop in prices.

Fed officials retained a generally firm stance on inflation and interest rates over the week with markets continuing to reduce expectations of a near-term cut in interest rates. US Treasury bond yields rose to the highest level since February.

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Confidence in the Euro-zone economy will remain robust in the short-term and the ECB remains firmly on track for an interest rate increase at the June council meeting. There is a risk that the economy will start to some signs of a slowdown in a response to higher interest rates and the property sector is liable to deteriorate. In this environment, the Euro will find it difficult to secure firm buying from current levels, especially with a series of interest rate increases already priced in.  

The Euro struggled to make headway with a retreat against the Swiss franc, yen and Sterling for the week as a whole.

The German industrial surveys continued to record firm figures, although with some evidence that sentiment was peaking. The ZEW index rose to 24.0 in May from 16.5 the previous month while the IFO index was unchanged from the previous month at 108.6.

Euro-zone industrial orders rose strongly by 2.7% in April for an 8.0% annual increase while the trade account recorded a comfortable surplus for March

ECB officials continued to indicate a firm stance on interest rate policy in comments during the week with markets focussed firmly on a June rate increase.

Yen 

The yen will remain vulnerable on yield considerations in the short-term with Japanese rates held at 0.5%. The Bank of Japan is still likely to take a tougher than expected stance on interest rates with the bank concerned over asset-price inflation and looking to raise rates as soon as possible. There is the potential for longer-term inflows into Japan and there are still substantial longer-term risks associated with carry trades. Yen losses should be limited from current levels and the risk of a rapid yen correction stronger will persist.      
                    
The yen weakened to lows near 122.0 against the dollar before recovering back to near 121.0. The yen also recovered from record lows near 164.0 against the Euro.

The Japanese economic data recorded a 0.1% decline in core consumer prices in the year to April.

The Bank of Japan minutes from April were tougher than expected and the impression given is that the central bank is looking for an opportunity to increase interest rates again as soon as is realistically possible.

The trade surplus increased to JPY0.93trn in April even though export shipments to the US slowed.

The latest capital account data recorded net inflows as overseas investment into Japanese securities offset further capital outflows.

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There will be expectations of further interest rate increase, especially after firm Bank of England minutes. There is, however, a risk that the economy will start to deteriorate following the increases already sanctioned. The underlying risks surrounding the property sector will also remain very high. Overall, Sterling has discounted a substantial amount of favourable news which will limit the potential for gains and the currency will also be vulnerable if there is any reversal of carry trades.   
 
Sterling found support close to 0.6850 against the Euro and strengthened to near 0.6760. Sterling also pushed to highs near 1.99 against the dollar before settling close to 1.9850

The Bank of England minutes from the May meeting indicated that the MPC did discuss the possibility of a 0.5% increase in rates. There was still a diversity of views over growth and inflation trends, but with the suggestion that further rate increases were likely.

Futures markets continued to expect further interest rate increases with some further speculation that rates will need to rise to 6.0% from 5.5% now.

The CBI industrial survey was firm for May with a higher prices index while the orders index was slightly stronger, although export confidence weakened slightly. GDP was un-revised at 0.7% for the first quarter with a 2.9% annual increase.

Swiss franc

The National Bank will be concerned over inflation trends in the short-term, especially with franc weakness adding to the upward pressure on import prices. The central bank will increase interest rates again in June and there is the possibility of a 0.5% increase to curb inflation. The bank will be very reluctant to target the exchange rate, but verbal intervention is likely to continue. The Swiss currency has been used as a global funding currency and will strengthen sharply if there is a sustained unwinding of carry trades.   
 
The Swiss currency weakened to lows around 1.66 against the Euro early in the week before strengthening back to 1.6485. The dollar struggled to sustain gains above 1.23 against the franc.

There were further warnings over franc weakness from National Bank officials during the week. SNB members Roth and Jordan both expressed greater concern over inflation and the impact of rising import prices.

Producer prices rose 0.9% in April, the highest monthly increase for 14 years, to give an annual increase of 2.6%.

There was some speculation that the bank would decide on a 0.5% interest rate increase at the June quarterly council meeting. The SNB was unwilling to give the impression that they would sanction intervention to support the franc.

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The Australian dollar was unable to strengthen above the 0.8270 level during the week and weakened back to below the 0.82 level with lows around 0.8180. The domestic influences remained limited during the week with a firm reading for leading indicators not having a significant impact.

Markets continued to speculate over a further increase in interest rates with optimism that near-term growth indicators would remain robust.

The Australian dollar was undermined by a drop in metals prices during the week while unease over Chinese trends contributed to a reduction in speculative positions.

The Australian currency will remain vulnerable to a further correction as high-risk positions are scaled back, but losses should be limited.

Canadian dollar

The Canadian dollar has remained strong over the latest week and tested the strongest levels against the US dollar since 1978 with gains to near 1.08.

There were no major Canadian data releases over the week, but optimism over the economy remained strong.

The Canadian dollar drew support from the high level of oil prices, although energy prices edged lower later in the week and commodity prices fell. The Canadian currency should remain strong in the short-term, but with a consolidation of recent susbstantial gains likely.

Indian rupee

The Indian rupee has remained generally strong during the latest week, but failed to make strong headway. There was tough resistance close to a 9-year high of 40.50 and the currency weakened to 40.60 on Friday.

There has been further evidence of at least limited central bank intervention to stem rupee gains which curbed the potential for a rupee advance. There has also been evidence of dollar buying from oil importers, especially with crude oil prices remaining at high levels.

The rupee was unsettled slightly by Asian stock market weakness on Friday, although the impact was still limited as overall sentiment remained strong.

The rupee remains vulnerable to a partial correction weaker, although heavy losses are unlikely unless there is a big drop in regional stock markets.

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The Hong Kong dollar has remained weak over the past week with lows near 7.8265, the weakest level since September 1985. The local currency strengthened slightly to 7.8240 on Friday.

Arbitrage activity continued during the week, especially as US Treasury bond yields rose over the week with markets taking advantage of lower Hong Kong interest rates.

There was a withdrawal of funds from Hong Kong which had been raised through IPO offerings by Chinese companies.

The Chinese policy changes at the end of last week did not have a significant impact on the Hong Kong currency.

The Hong Kong dollar is likely to remain weak in the short-term, but losses should be very limited from current levels.

Chinese yuan

The Chinese yuan has continued to strengthen gradually over the past week with gains to around 7.6540 on Friday.

The Chinese central bank announced an interest rate increase and higher reserve requirements at the end of last week. The bank also widened the maximum daily yuan trading band to 0.5% from 0.3%.

The US-China bilateral talks over trade failed to have a major impact, with further US pressure for a faster rate of yuan appreciation resisted by the Chinese authorities.

Former Fed Chairman Greenspan warned that the Chinese stock market was vulnerable to a sharp decline, although the market reaction was contained with only small-scale losses.

The underlying pressure for a stronger yuan will continue in the short-term and the central bank is likely to allow further gradual appreciation.