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The Week Ahead
Overall strategy: Carry trades will remain an important factor with position adjustment triggering further volatility, although the initial phase of high-yield currency selling has probably been completed. The dollar should be able to retain a firm tone on favourable yield spreads with solid support weaker than 1.30 against the Euro.
Key events for the week to follow
Date Time (GMT) Data release/event
Tuesday 13.30 US GDP (advance)
Wednesday 19.15 US Federal Reserve interest rate decision
Thursday 15.00 US ISM index (manufacturing)
Friday 13.30 US Non-farm payrolls data
Dollar
Interest rate trends should be positive for the dollar with US bond yields at a five-month high. Expectations that the Fed will keep interest rates on hold will also underpin capital inflows and the currency should prove resilient in the short-term. There will be concerns over the risk of underlying reserve diversification away from the US dollar and the currency is still likely to hit tough resistance stronger than 1.29 against the Euro due to central bank selling.
There was little in the way of US growth data for most of the week and the dollar found it difficult to gain independent direction as cross trading remained an important feature. The dollar did, however, find firm support close to 1.3050 against the Euro and strengthened to near 1.29.
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There was a small decline in existing home sales to an annual rate of 6.22mn in December from 6.27mn the previous month, but inventories fell and prices held firm which offered reassurance over underlying trends.
Comments from Federal Reserve officials remained generally firm over the week with suggestions that interest rates would be left on hold throughout the first half of the year. US treasury yields rose during the week with 10-year yields rising by around 10 basis points to a five-month high close to 4.90%.
Euro
There is the risk of further position adjustment in the short-term with the correction against the yen undermining wider Euro support. Although the German IFO survey was weaker, a sustained period of disappointing data releases will be need to undermine expectations of a March interest rate increase. Overall currency demand should remain firm which will limit Euro retreats.
The Euro was slightly weaker during the week as a whole, although the trends were mixed as position adjustment remained an important factor with losses against the yen offset by gains against Sterling.
The German IFO index weakened to 107.9 in January from 108.7 the previous month with confidence likely to have been sapped by the VAT increase to 19%. Sentiment was, however, still at a historically high level as business expectations edged stronger. Data elsewhere was firm with strong Euro-zone money supply growth.
The ECB continued to take a firm stance on monetary policy with official comments continuing to suggest that a March rate increase is likely.
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Yen
A further reduction in short yen positions is realistic given that they were running at extreme levels and the scope for yen gains will be much larger if there is sustained verbal intervention against yen weakness from G7 officials. There will still be interest in selling the yen on yield grounds, especially as the markets still have very little confidence in the Bank of Japan. Overall, the yen will struggle to sustain any near-term gains.
Yen volatility increased significantly over the week as carry trades dominated trading. The Japanese currency weakened to three-year lows near 122.0 against the dollar.
Over the second half of the week, there was a sharp reduction in carry trades and this helped trigger a sharp yen rally to 120.20 against the dollar on stop-loss buying, but the yen weakened again on Friday.
The yen also secured support from media reports that European officials would criticise yen weakness more strongly at the February G7 meetings while investment inflows were firm.
Comments from Bank of Japan officials were mixed over the week with no clear policy hints. Governor Fukui stated that the bank would err on the side of caution while bank member Suda urged the bank not to delay an increase. The inflation data was subdued with core prices rising 0.1% in the year to December.
Sterling
The Bank of England minutes will dampen expectations of another first-quarter interest rate increase and expectations of the peak level in rates are also likely to be scaled back. This combination is likely to weaken Sterling's underlying trading range in the short-term and there is also scope for a further reduction in long Sterling positions. The UK currency should be able to avoid heavy short-term selling pressure given that growth indicators have remained firm with support near 1.95 against the dollar.
Over the first half of the week, Sterling strengthened to fresh 30-month highs against the Euro and a 14-year high against the dollar with peak above 1.99.
The economic data remained generally firm with GDP rising a provisional 0.8% for the fourth quarter, the strongest rate for close to three years.
The Bank of England minutes were an important feature over the week following the surprise decision to increase interest rates. The minutes recorded a 5-4 vote for a January increase with the four dissenting members wanting to wait for further evidence on inflation. The majority saw little risks in increasing rates now and promoted the increase on the grounds of stemming inflationary pressure.
The narrow decision caused some uncertainty over policy, especially as the bank’s chief economist voted against the increase. Markets moved to reduce expectations that two further rate increases would be required and also cut the chances of a further increase within the next 2 months. This adjustment in expectations pushed Sterling weaker to 0.66 against the Euro and 1.9635 against the dollar
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Swiss franc
Global position adjustment will remain a very important factor in the short-term. The franc has struggled to gain support from a yen correction and the lack of National Bank inflation concern will dampen expectations of higher Swiss interest rates. Nevertheless, there is the potential for franc support beyond 1.25 against the dollar.
The Swiss franc was dominated by yield plays over the week. Ranges against the dollar were relatively narrow with the Swiss currency finding support close to the 1.2520 level against the dollar, but the franc was volatile against the Euro. The franc tested support levels weaker than 1.62 before strengthening back to 1.6120.
Selling related to carry trades was strong early in the week, but there was significant pressure for a correction as positions became over extended.
National Bank Chairman Roth stated that the franc weakness was at odds with the economic fundamentals and warned that interest rates would be increased if there were risks to price stability. Roth, however, also stated that he was very confident over the 2007 inflation outlook.
Australian dollar
The Australian dollar strengthened to highs above 0.7920 against the dollar before weakening sharply with lows around 0.7725 on Friday. The consumer inflation report was weaker than expected with a headline 0.1% drop in prices for the fourth quarter. The underlying increase was held to 0.5% which pushed the annual rate back to just below the 3.0% Reserve Bank ceiling.
The weaker than expected inflation data undermined interest rate expectations with the chances of a first quarter increase cut to around 10% from 50% previously.
This undermined the Australian dollar and the currency was also vulnerable to long closing positions funded through the yen. Uridashi bond redemptions will remain an important short-term influence and will hamper rally attempts, but some short-term stabilisation is realistic.
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Canadian dollar
The Canadian dollar was subjected to considerable volatility over the week. The headline economic data had a weaker than expected bias with the core inflation rate falling to 2.0% in December from 2.2% the previous month. There was also a drop in retail sales, although the underlying spending data was firm.
Commodity prices were an important influence and the sharp recovery in oil prices to the US$55 p/b level from lows near US$50 helped support the Canadian dollar. Overall confidence in the currency will remain weak in the short-term, but further support is realistic close to the 1.1850 level.
Indian rupee
The rupee secured marginal gains over the week as a whole, but struggled to secure significant gains due to conflicting market factors. The yen’s recovery against the dollar offered some rupee support and the local stock market reached a record high during the week which boosted capital inflows.
These positive factors were offset by month-end dollar demand to meet oil imports and the negative impact was compounded by higher oil prices.
There was further evidence of central bank rupee selling close to the 44.20 level which curbed more aggressive buying of the currency. The central bank will continue to intervene, but there is scope for the rupee to edge stronger.
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Hong Kong dollar
The Hong Kong dollar avoided a further retreat to 17-year lows around 7.812 against the dollar seen at the end of last week, but the currency was trapped weaker than the 7.80 central rate.
Hong Kong interest rates remained lower than equivalent US rates and this contributed to further arbitrage selling of the local currency. Losses were contained by solid corporate demand for the local currency.
The HKMA denied intervening in the market, but there was further speculation that the monetary authority was allowing the Hong Kong dollar to weaken in order to discourage speculation that the currency will be allowed to strengthen with the yuan. In the short-term, the Hong Kong dollar will struggle to secure significant appreciation
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