Weekly Forex Currency Review 20-06-2008

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Overall strategy: Growth and interest rate expectations will remain extremely important in the short-term. The scaling back of US interest rate expectations will unsettle the dollar in the near term, but the Euro-zone will be at risk of increased capital outflows which will make it difficult for the currency to make significant headway.  Central bank policy actions will remain a key short-term focus for the markets.                    

Key events for the forthcoming week

Dollar:

The most recent data releases have not supported the more optimistic tone seen following the retail sales data, although there will still be some cautious optimism that a serious deterioration can be avoided. Markets have pared back the most aggressive expectations towards interest rates, but the Federal Reserve will need to monitor inflation risks very closely. The economic conditions are unlikely to trigger strong dollar support in isolation. There is, however, scope for investment inflows after the robust capital account reading and fears over a deterioration in the European economy is likely to provide significant dollar support.  

The dollar was unable to extend the strong gains seen last week and had a generally weaker tone with lows back towards the 1.56 level against the Euro as markets probed well-defined ranges. The US currency also edged lower on a trade-weighted basis

The US growth-orientated data offered little support to the US currency over the week. Housing starts wakened to a 17-year low with the annual rate below the 1.00mn rate, although this was close to market expectations and the level seen the previous month with little change in permits. The New York manufacturing survey deteriorated over the month while there was also a renewed deterioration in the Philadelphia Fed index to -17.1 from -15.6 previously.

As far as the balance of payments was concerned, the current account deficit was little changed at US$176bn in the first quarter of 2008 from US$167bn in the previous three-month period. There were strong long-term capital inflows of US$115bn for April from a revised US$60.4bn the previous month which provided some reassurance over the capital account.

Inflation concerns were still a significant focus with producer prices rising 1.4% for May, although the core increase was held to 0.2% and the impact was limited.

The net impact was still a downward adjustment in US interest rate expectations with markets not expecting the Federal Reserve to push interest rates above the 2.50% level this year while stability is expected at next week's FOMC meeting. There were no major policy comments from key Federal Reserve officials over the week

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Overall confidence in the euro-zone economy is liable to weaken as there is a further deterioration conditions and the threat of increased divergence between individual economies. The ECB will want to take a tough stance on interest rates, but the Swiss decision to leave rates on hold will create some doubts over a July move. A rate increase when the economy is under pressure would also not offer strong currency support. There will also be further political stresses following the Irish Lisbon Treaty referendum which will unsettle the Euro.       
       
The Euro had a firm tone against low-yield currencies during the week, but struggled to make strong headway and generally weakened against higher-yield currencies.

Headline May Euro-zone inflation was revised up slightly to 3.7% from a provisional 3.6% while the core annual rate increased to 1.7% from 1.6% previously.

ECB officials maintained a tough stance on inflation and suggested that interest rates would be increased at the July meeting. There were, however, also comments that a series of rate increases was unlikely while Bin-Smaghi stated that one increase should be enough to get inflation back to the target level. The Swiss decision to hold rates steady triggered some speculation that the ECB would not increase rates in July.

The economic data was generally weak with the ZEW economic expectations index falling to -52.4 in June from -41.4 previously with fears that bank loan conditions would be tightened. The German Finance Ministry stated that there was liable to be a significant economic slowdown while further Euro strength should be resisted.

There were further political discussions over the EU constitution following the Irish Lisbon Treaty rejection at the end of last week.

Yen:  

There has been further evidence of a domestic economic slowdown and the Bank of Japan will be very reluctant to raise interest rates even with an increase in inflationary pressure. There will, therefore, be scope for further capital outflows from Japan on yield grounds. The yen will still gain some support when risk aversion increases, especially if there are renewed fears over the financial sector. There will be pressure for a correction, but the Japanese currency is unlikely to make strong headway in the short-term.
                    
The dollar continued to attack highs above 108.50 against the Japanese currency before consolidating just below the 108.0 level. The Euro also pushed to 11-month highs against the Japanese currency before correcting slightly weaker.

The Bank of Japan continued to warn that the economy faced conflicting pressures with weaker growth in tandem with rising inflation. The economic data was generally weak with the monthly Tankan manufacturing index remaining at a 5-year low

The yen was unsettled on yield grounds with some flow of funds into high-yield currencies, but the yen secured some relief when there was downward pressure on global equity markets with caution over the global economic condition.

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Overall confidence in the economy will remain weak with further speculation over recession. Markets were already speculating that the Bank of England could be forced to increase interest rates to stem inflationary pressure and the new MPC is likely to be slightly more hawkish. The surprise surge in retail sales will also jolt near-term expectations and increase speculation over higher interest rates. In this environment, there may be scope for a further Sterling rally, although strong gains still look unlikely in current circumstances.
 
After sharp mid-week losses, Sterling found support below 1.95 against the dollar and 0.7950 against the Euro before recovering strongly following the retail sales data.

Consumer inflation rose to 3.3% in May from 3.0% the previous month while the core rate rose to 1.5% from 1.4% previously and the underlying RPI rate also rose strongly to 4.5% which triggered some fears over higher wage demands.

Given the increase in inflation, the Bank of England was forced to write an explanatory letter to the Chancellor explaining the inflation rise. Bank Governor King noted that the path of interest rates to meet the inflation target was unclear. Despite the inflation warnings, the comments also suggested that there would be a reluctance to raise interest rates given the risk to the economy.

The minutes from June's meeting recorded an 8-1 vote for unchanged rates. Blanchflower again voted for a rate cut, but some members considered calling for a rate increase given the inflation fears.

The retail sales report provided a major jolt to the markets with a 3.5% monthly increase which was the strongest on record. There were suspicions that the data had been distorted by warm weather and price discounting, but there was still increased speculation that the Bank of England would increase interest rates.

The personnel changes at the Bank of England triggered speculation over a slightly more hawkish policy bias as Bean was appointed Deputy Governor.

Swiss franc:

The National Bank decision to leave interest rates on hold will tend to undermine the franc in the short-term, especially as there will be a suspicion that the bank is more worried over economic conditions with a particular focus on the banking sector. The franc will still gain some defensive support, especially when stock markets are subjected to sustained downward pressure. There is, however, reduced scope for strong franc gains.   
 
The franc strengthened to highs around 1.03 against the dollar, but was unable to sustain the gains and retreated to 1.0450. The franc was weaker against the Euro.

The National Bank left interest rates on hold at 2.75% following the latest quarterly council meeting. The bank left growth forecasts unchanged while the inflation forecasts for the next two years were increased. There was a discussion as to whether rates should be increased and Bank President Roth also stated that a September rate increase was a possibility.

The bank's reluctance to increase rates despite the higher inflation forecasts sparked some speculation that the bank is more concerned over conditions within the economy with a particular focus on the banking sector amid the threat of debt write-downs.

The Swiss ZEW expectations index fell to -63.8 in June from -60.4 the previous month which reinforced expectations of a slowdown in the economy. There was also a decline in first-quarter industrial output while adjusted retail sales dipped sharply

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The Australian dollar found good support close the 0.93 level against the US currency and pushed stronger over the week with a high above the 0.95 level.

The Reserve Bank minutes stated that the bank was optimistic that interest rates were high enough and this dampened expectations that the bank would tighten policy again. The currency still found support on yield grounds as US expectations were lowered

The Australian currency drew some support from capital inflows from Japan during the week while industrial commodity prices provided some support.

Overall, despite continuing yield support, the Australian dollar will struggle to secure more than limited further gains against the US currency. 

Canadian dollar:

The Canadian dollar found support weaker than 1.02 against the US dollar and had a generally firmer tone over the week, but hit resistance close to 1.01.

Consumer prices rose 1.0% in May as energy costs rose strongly while there was a 0.3% increase in core prices to give a 1.5% annual increase. The inflation data further dampened expectations that the Bank of Canada would be able to cut interest rates.

The Canadian dollar gained support at times from a rally in oil prices during the week, although trading conditions were choppy.

Overall, the Canadian currency is likely to remain blocked on any rallies towards parity against the US dollar with energy prices triggering significant volatility.

Indian rupee:

The rupee was again generally fragile during the week with a further test of support levels close to the 43.0 level against the US currency.

The Indian currency was again unsettled by fears over capital outflows as the stock market was generally weaker. The market has fallen around 25% this year which has fuelled fears over capital outflows and rallies quickly attracted selling pressure.

There was some further speculation that the Reserve Bank was intervening to support the local currency when it dipped to the 43.0 region and higher than expected inflation data also provided some degree of support o the rupee on Friday..

Overall, the Indian currency is unlikely to make much headway in the short-term with further unease over the threat of further capital outflows.

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The Hong Kong dollar has remained weaker than the 7.80 central rate against the US currency, but did find beyond the 7.81 level with little overall change.

There was a decline in US interest rate expectations over the week which provided some support to the Hong Kong dollar as arbitrage activity was at reduced levels.

There were further concerns over the local stock market conditions with the Hang Seng index unsettled by sharp declines in the main Chinese markets and this was a negative influence on the Hong Kong dollar.

The Hong Kong dollar should again be able to resist significant losses against the US currency as arbitrage activity will dip with some consolidation weaker than 7.80. 

Chinese yuan:

The yuan continued to strengthen during the week with record highs beyond the 6.88 level against the US dollar before some consolidation on Friday.

At the latest Sino-US talks US officials continued to promote gains for the Chinese currency and there were no major pubic announcements regarding the yuan.

There were persistent fears over the Chinese inflation outlook with particular fears over impact of rising food and energy costs as Chinese increased fuel prices. These pressures created speculation that the authorities would push for a stronger currency.

The policy dilemmas were illustrated by the calls from exporters for yuan gains to be curbed while the Chinese authorities also warned against excessive dollar weakness.

Overall yuan volatility is liable to remain high over the next few weeks. The net flows still suggest that net appreciation is realistic, although substantial gains look unlikely given a slightly firmer US dollar tone   

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