by Darrell Jobman, Editor-in-Chief

Conditions within the global economy remained a crucial focus over the week with a downgrading of expectations an important source of dollar support. There was also further important position adjustment with a reduction in commodity positions and weakness in high-yield currencies. This combination of factors allowed the US currency to advance for 11 successive days on a trade-weighted basis to a six-month high.

US retail sales edged lower by 0.1% in July as auto sales weakened with a 0.4% underlying increase while there was a small upward revision to June’s data.

The trade deficit fell to US$56.8bn for June from a revised US$59.2bn the previous month. There was a 4.0% increase in exports for the month which was the strongest increase for over four years. Following the trade data, there were upward revisions to the second-quarter GDP estimates on a positive export contribution.

Consumer prices rose a headline 0.8% in July after a 1.1% increase the previous month as food and energy prices continued to increase with the 5.6% year-on-year increase the highest for 17 years. There was also a second successive 0.3% increase in core prices with the annual core rate at 2.5% which maintained inflation fears.

Despite the inflation data, there was no great shift in interest rate expectations with markets sceptical that the Fed would be in a position to tighten policy while major doubts over the economy persisted, especially as credit stresses persisted.

There was a 0.5% decline in German GDP for the second quarter, although this was slightly stronger than expected following the first-quarter surge. In contrast, the French economy contracted 0.3% in the quarter which was worse than expected and overall Euro-zone GDP fell by 0.2%, the first quarterly decline since the Euro area was created.

The final consumer inflation estimate was slightly below the flash estimate at 4.0% from the 4.1% expected while the core rate was at 1.7%. There was increased speculation that the ECB would shift to a less restrictive policy later in 2008.

US Dollar Index
Source: VantagePoint Intermarket Analysis Software

The dollar continued to advance against the Euro with fresh 6-month highs near 1.47 on Friday as European fears increased.

There was some evidence of some liquidation in carry trades as global growth fears increased and commodity prices came under pressure. The latest capital account data also recorded strong net inflows into Japan.

The second-quarter GDP data recorded a 0.6% decline, the weakest outcome for seven years and reinforced the suspicion that the economy had entered recession. Overall consumer confidence also weakened to a record low according to the latest data, reinforcing fears over the consumer spending outlook while the monthly Tankan business confidence index dipped to a fresh 5-year low.

The Japanese currency advanced against the Euro and the commodity currencies, but was unable to sustain an advance against the dollar. The drop in commodity prices and expectations of lower interest rates put strong downward pressure on the Australian dollar with 7-month lows around 0.86 against the US currency.

The UK growth-related data remained generally weak over the week. The BRC retail sales monitor recorded a 0.9% drop in like-for-like sales for July while the latest RICS house-price index recorded a further decline in activity. There was a further unemployment increase of over 20,000 for July, the largest increase for 16 years.

As far as inflation is concerned, the headline consumer inflation rate rose sharply to 4.4% from 3.8% the previous month while the core rate rose to 1.9% from 1.6% and the Retail Prices index was above 5.0%.

In its quarterly inflation report, the Bank of England warned that inflation would peak close to 5.0% this year, but would then fall sharply and would be slightly below the 2.0% level in two years time assuming rates were left unchanged.

The bank downgraded its growth forecast for the economy and Bank Governor King was notably downbeat over the economic prospects with warnings over a difficult year ahead. Following the report, markets moved towards pricing in an interest rate cut before the end of 2008 which kept the UK currency under pressure.

The UK currency remained under strong pressure during the week with the trade-weighted index retreating to the lowest level for 11 years. The UK currency weakened for 11 successive days against the dollar with lows around 1.8550 while Sterling dipped sharply from levels near 0.78 against the Euro.