Weekly Forex Currency Review 07-11-2008

Overall strategy: 

There will be continuing fears over the global economy as growth conditions continue to deteriorate. These pressures will be in conflict with an easing of credit-related stresses while there will also be more forward-looking optimism that aggressive action to lower interest rates will help stabilise economic conditions.  Overall demand for the US currency is liable to be slightly weaker, but volatility will remain extremely high.

Key events for the forthcoming week

Dollar:

There will be fears over a further deterioration in the economy, especially after a series of bleak economic data releases over the past week. The Federal Reserve will have to maintain a very low interest rate policy and could sanction a further cut if there is evidence of further downside pressure. The dollar will continue to gain some defensive support on financial and economic fears, although the overall evidence suggests that capital repatriation has declined. There will be further fears over the fiscal outlook while trade tensions are also liable to increase. Indications over Obama's policy stance will be very important and the huge financing requirement will unsettle the US currency.

The dollar continued to fluctuate sharply over the week and, after sharp losses around the middle of the week, there was a sharp recovery against European currencies.

There was a significant decline in Libor interest rates over the week as liquidity improved. As market rates declined, dollar rates dipped to their lowest level since late 2004. Equity markets were firm early in the week, but failed to sustain the gains and renewed declines helped underpin the US dollar as defensive demand persisted.

The US data releases had a consistently weak tone. The ISM index for the manufacturing sector fell sharply for the second successive month with a decline to 38.9 from 43.5 previously. This was the weakest figure since 1982 and indicated that the economy as a whole is in recession, especially with depressed readings for employment and orders. The services-sector reading also declined to 44.4 in October from 50.2 the previous month with another weak employment reading.

There was also a further decline in factory orders and job cuts also continued to increase while auto sales fell sharply. The latest ADP report also recorded a decline in private-sector employment of 157,000 for October. The latest US jobless claims were again relatively steady in the latest week at 481,000 while continuing claims were at a 25-year high. Following the data releases, markets continued to price in further interest rate cuts by the Federal Reserve

Democrat Senator Obama secured a very convincing win in the electoral college vote for President, although the popular vote was closer. In the congressional elections, there were also further Democrat gains, although they fell short of winning the 60 seats required in the Senate to neutralise Republican opposition

Fed officials were generally downbeat over economic prospects and also downplayed inflation expectations as economic fears dominated, although Lacker did warn over the need to avoid keeping rates too low for too long.

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The Euro-zone economy will continue to weaken in the short-term , especially with export markets under pressure. The ECB is likely to cut interest rates further over the next few months. There will be some disappointment that the bank is not cutting rates at faster pace as markets look to reward pro-active stances. The Euro-zone is less exposed to very high consumer debt levels which should provide some degree of protection to the currency provided that internal stresses and widening bond spreads can be contained. 
       
The Euro advanced strongly at times, but failed to sustain the advance and retreated again late in the week as European sentiment remained very fragile. There was a low near 1.2650 against the dollar and it failed to sustain an advance against the yen.

At the latest ECB council meeting the central bank cut interest rates by a further 0.50% to 3.25%. In the press conference following the decision, Chairman Trichet stated that there had been discussion over whether to cut by a more aggressive 0.75%, but caution prevailed given that rates had also been cut in October.

The bank stated that inflationary pressures should continue to decline while growth risks remained to the downside. Despite a very high degree of uncertainty, the comments overall suggested that the bank would cut rates further. Markets remain fearful over growth prospects and there was some initial disappointment that the bank did not sanction a deeper cut in interest rates.

The Euro-zone data remained generally weak with a downward revision to the October PMI data, especially within the services sector. The latest German industrial data registered a record 8.0% monthly decline in orders for September.

There were further stresses within the European bond markets as German/Italian yield spreads continued to widen.

Yen:  

The economy is liable to weaken further in the short-term  with domestic spending weak and a downturn in exports. The Bank of Japan will be very reluctant to sanction any further interest rate cut from current levels and underlying confidence in the economy will remain weak. The yen moves will still be correlated with degrees of risk aversion and there will be a reluctance to push funds overseas given the weaker global growth outlook. The Japanese authorities are likely to oppose sharp yen gains, especially given increased economic fears.

The Japanese yen found support weaker than the 100 level against the dollar and pushed back to 97.50 as equity markets weakened again. The yen also reversed intra-week losses against the Euro.

There was an initial rebound in the Nikkei index which provided some encouragement for a flow of funds overseas, especially as stresses in the financial sector eased.

There were still increased fears over the economic outlook which curbed enthusiasm for carry trades, especially with the prospect for lower global interest rates. Equity markets slipped sharply over the second half of the week and risk aversion also increased again which curbed any yen selling pressure.

There were warnings over the economy from Bank of Japan Governor Shirakawa while former top Finance official Sakikibara warned that the yen could appreciate rapidly due to market de-leveraging. The profit warnings from Japanese currencies also sparked speculation over opposition to yen gains.

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The economy will continue to waken the short-term , but the very aggressive interest rate cut is likely to stabilise confidence. There will also be some relief that the bank is taking a pro-active stance in attempting to support the economy. The UK currency will be more vulnerable on yield grounds, especially with rates now in the very unusual position of being below the level of Euro rates.  Sterling will still find it difficult to make much headway given the underlying economic fears with volatile trading still a key market feature. 

Sterling rallied strongly at times, but was unable to sustain the gains in very volatile conditions and suffered renewed losses as domestic and international conditions deteriorated over the second half of the week. Sterling dipped to lows below 1.56 against the dollar and re-tested record lows against the Euro near 0.82

The manufacturing PMI index was slightly stronger than expected at 41.5 from 41.2 the previous month. There was a further decline in the construction and PMI indices with the services data at a record low. The official industrial production data continued to register a decline, the seventh successive monthly decline.
There was a recovery in the latest Nationwide consumer confidence data, but underlying evidence continued to suggest weak spending trends and house prices continued to decline according to the latest surveys.

The Bank of England sanctioned a much larger than expected interest rate cut with a cut in the base rate by 1.50% to 3.00%. This was the largest decline for over 25 years and also pushed rates to 50-year lows.  The bank stated that economic conditions had deteriorated sharply over the past few weeks and there was a substantial risk of inflation undershooting the 2.0% target.

Swiss franc:

The economy will continue to slow and the National Bank fears over the economy have been illustrated by the decision to cut interest rates again ahead of the regular council meeting. The franc trends will also be influenced strongly by the degree of confidence in the global financial markets with the franc gaining some support when fear increases. The Swiss currency will struggle to make strong headway given the increased domestic vulnerability, especially with financial risks still slightly lower.

The franc was generally weaker against the Euro, although it did find support weaker than the 1.50 level. The Swiss currency weakened to re-test support levels near 1.18 against the dollar.

Consumer prices rose 0.5% in October on seasonal grounds and the annual rate declined to 2.6% from 2.9%. The PMI index remained trapped below the 50.0 level and was at a 60-month low, although it was slightly better than expected.

National Bank officials expressed increased unease over the economy with Chairman Roth stating that concerns had increased over the past few weeks which reinforced market expectations of lower interest rates.

In the event, the National Bank announced a surprise interest rate cut of 0.50% which took the central rate down to 2.00% from 2.50% previously and there were warnings over a GDP contraction for the next few quarters in comments on Thursday.

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The Australian dollar found support on dips towards the 0.66 level against the US currency, but failed to break above the 0.70 level as high volatility continued.

The economic data was mixed, but still had a weaker bias. The PMI indices were all still comfortably below the 50.0 expansion threshold, although there was a monthly recovery in the construction reading from very depressed reading in September.

The October labour-market data was stronger with unemployment held at 4.3% while there was a 34,000 employment increase. The Reserve Bank still cut interest rates again with a 0.75% cut to 5.25% compared with market expectations of a 0.50% cut.

Volatility is likely to remain a key feature with the Australian dollar still in a position to secure a net corrective recovery against the US dollar.

Canadian dollar:

The Canadian dollar rallied strongly to levels beyond 1.15 against the US dollar, but failed to sustain the advance as volatility remained very high. The Canadian dollar drew short-lived support from a rebound in commodity prices and an improvement in risk appetite as stock markets rallied.

The PMI index weakened to 52.2 in October from 61.0 the previous month, although the immediate impact was limited as it is a volatile series.

Volatility is likely to remain a key short-term feature for the Canadian dollar with the potential for a further limited underlying correction stronger from recent heavy losses.

Indian rupee:

The rupee secured a sharp corrective recovery early in the week and secured the largest one-day gain for 10 years during an advance to near 47.50 against the dollar and this was the strongest level for a month.

The rupee was boosted by a recovery in the local stock market as risk appetite staged a recovery. The currency struggled to hold the gains as underlying sentiment deteriorated again. Net capital outflows have amounted to around US$12.8bn for the year as caution has prevailed with funds pulling funds out.

The central bank action to provide dollar liquidity directly to the major companies will remain important in helping to support the rupee, but it will struggle to make much further headway given the global downturn.

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The Hong Kong dollar has continued to test the 7.75 band limit against the US currency over the week as currency strength has persisted.

The HKMA has continued to inject liquidity to bring rates down and curb currency strength while it also extended collateralized lending to 3 months to ease stresses. Despite these measures, underlying demand for the currency remained robust.

The Hong Kong dollar should retain a firm tone in the near term and there is likely to be increased speculation over a move to widen the currency band.

Chinese yuan:

The Chinese currency has remained trapped in relatively narrow ranges over the past week. The central bank has maintained a determined stance to avoid instability with the yuan close to 6.8250 against the dollar on Friday.

There were renewed fears over capital account stresses and fresh measures were introduced to prevent capital outflows. There was increased speculation over the potential trade and currency policies that would be pursued by the new US administration with some expectations that they will push for faster yuan gains.

The principal concern of the Chinese authorities is likely to be to maintain yuan stability. There will be further concerns over the growth outlook and a continuing bias towards lowering interest rates will tend to curb currency support. 

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