Currency Analysis – September 11, 2007

The dollar failed to hold stronger than 1.38 against the Euro on Tuesday and weakened to lows around 1.3845, very close to the record 1.3850 low seen in July. The US currency also weakened to a fresh 15-year low on a trade-weighted basis.

In comments on Monday, Fed Governor Mishkin, who is a voting member of the FOMC, stated that there were important downside risks to the economy. Fed Chairman Bernanke declined to make any comment on the economy or interest rates on Tuesday. The fact that Bernanke did not aim to dampen increasing market expectations over an aggressive interest rate cut will continue to fuel speculation over a 0.50% cut in Fed funds rates next week. In response, Treasury bond yields also fell which tended to undermine the dollar, especially as rising global stock markets lessened defensive dollar demand.

The US trade deficit fell to US$59.2bn in July from an upwardly-revised US$59.4bn the previous month with a solid export performance, but the data failed to have a significant impact with markets focussed firmly on interest rate trends and growth prospects.

The ECB took a generally confident stance on economic prospects and also took a firm stance on policy. President Trichet stated that the bank is always being asked to lower interest rates and repeated that medium-term inflation risks were biased to the upside. This firm stance will underpin the Euro initially, although the underlying risks should not be ignored.

The yen failed to strengthen through the 113.0 level against the dollar on Tuesday. The US currency also probed levels above 114.0 as Wall Street rallied and high-yield currencies secured renewed buying support.

The Japanese machinery orders data was much stronger than expected with a 17.0% monthly increase for July. The data is highly erratic on a monthly basis, but the strong increase will remove an important source of downside risk for the economy and yen as fears over capital spending trends triggered by the GDP data should ease.

There will be further capital outflows from Japanese investment trusts which will tend to offset potential capital inflows triggered by fears over the global economy. The rise in Chinese inflation to the highest level since 1996 will reinforce pressure for a further increase in Chinese interest rates which will provide some background yen support.

Sterling remained under pressure against the Euro on Tuesday, testing levels beyond the 0.68 level, but the UK currency recovered from lows below 2.0250 against the dollar to trade back above 2.03.

A UK mortgage lender Victoria Mortgages has filed for administration, illustrating that the sub-prime difficulties and rising market rates are having a negative impact on the UK mortgage sector. The immediate currency impact has still been limited, but the medium-term risk profile surrounding the property sector and currency remains very high.

The visible global trade deficit widened to GBP7.1bn in July from an upwardly-revised GBP6.5bn in June. Although the data remains erratic, the deterioration will increase concerns over UK competitiveness. The admission of a GBP300mn error in the previous figure will not improve market confidence in the data’s accuracy and this will limit its near-term impact.

Swiss franc

The Swiss currency failed to hold levels beyond 1.1850 against the dollar and weakened to 1.1885 in US trade as the Swiss currency came under pressure against the Euro. The franc was undermined by gains on Wall Street which triggered some renewed demand for high-yield currencies.

Movements in global stock markets will continue to have an important impact and, despite near-term global stock market gains, the underlying credit-related stresses will need to be monitored closely as there is a risk of substantial franc buying pressure.

With meetings held quarterly, the National Bank will be reluctant to defer a further monetary tightening unless there is clear evidence that a further rate increase will not be required.

Australian dollar

The Australian dollar resisted a further test of support below 0.82 against the US currency on Tuesday and rallied to levels around 0.8285 in local trading. A firm business survey provided some support to the currency, although the impact was limited with global market conditions still dominant. There were no further major negative developments and commodity-related currencies have gained ground on higher prices.

Caution will prevail in the short term and there will still be a reluctance to extend high-yield positions even though increased confidence pushed the Australian dollar above 0.83 in US trading.