Forex Investment and Currency Trading

1 - 3 Month Outlook

The underlying pressure for CNY to appreciate is illustrated by the fact that China’s FX reserves have increased by almost $300bn so far this year. Latterly, the pace of revaluation has slowed, particularly against the US dollar, in the face of weaker growth in the OECD economies, and there have been hints that the authorities have become more growth and less inflation focused. Nevertheless, given the size of the trade surplus and strength of FDI inflows, the positive trend in the yuan is expected to continue in the short term.

6 - 12 Month Outlook

Real GDP growth slowed in Q2, although the sequential growth rate actually picked up and the production, investment and retail sales data published towards the end of the quarter was firm. The contribution to the annual growth rate from net exports continues to diminish, while consumption shoulders more of the burden of expansion. Meanwhile, CPI Inflation continues to retreat from its early year highs. Base effects and lower food prices suggest that the disinflationary trend will continue over the remainder of the year, but the government has little room for complacency, especially given a tendency for PPI inflation to pick up. Given a less auspicious external growth environment, there has been some speculation that the government is about to signal a reversal of the tightening trend in monetary policy, but any changes in the short term are likely to be largely cosmetic. The government may also use the room facilitated by lower headline inflation to scale back its price controls. Oil and electricity prices remain well below cost and this has resulted in power shortages.

The government wants to bring real deposit rates into positive territory over the medium term, but progress is likely to be slow for now. Increases in reserve requirements will continue to be used as a mechanism to mop up excess liquidity and ensure that monetary growth is kept under control, although there are concerns about the impact on the banking system. Despite the more conservative pricing of NDFs of late, external political pressures for appreciation are unlikely to wane.

USD was the worst performing G10 currency overnight with DXY falling to a low of 73.976, relinquishing most of yesterday’s gains. In the US today, data will take the form of initial jobless claims, pending home sales, and consumer credit, though focus will lie firmly on non-US data with the BoE and ECB announcing rates. Both banks are expected to leave rates on hold, while focus for EUR will be on the ECB press conference which follows

USD/CAD drifted lower from the 9-month high of 1.0495 seen yesterday, before catching a bid as London opened to recoup some of those losses. The only Canadian data out today are building permits which are expected to fall 1.0%m/m in June.

EUR/USD was driven up towards the 1.55 handle overnight, peaking at 1.5487 ahead of today’s ECB rate decision. Market expects rates to be left on hold at 4.25%. European activity data have taken a turn for the worse of late, supporting the view that next move in rates will be a cut, though lingering concerns over second round effects may well see the Bank issuing further hawkish sound bites in the coming months. As for the subsequent ECB press conference, market expects the Bank to reiterate its neutral bias but to more likely assert its room for manoeuvre should wages pick up rather than hint at a possible easier policy stance. If the ECB surprises and indicates a more dovish stance than the July statement when ECB President Trichet said “I have no bias” and later repeated “we have no bias”, EUR could test 1.53.

GBP was softer overnight with EUR/GBP rallying up to a high of 0.79380, helped by the release of yet further weak housing data as HBOS July house prices printed below expectations. Market expects the BoE to leave rates on hold at 5.00% later today. The recent clear deterioration of an already poor growth outlook leads market to expect the majority in UK vote will conclude that the best course of action is inaction. Barring a shock interest rate change, GBP will likely  be unfazed by the BoE decision.

AUD/USD edged higher off the 4-month low seen yesterday following stronger than expected July employment numbers. Employment rose by 10.9k in July although the previous month was revised down, while the unemployment rate held steady at 4.3% as expected. These data are lagging however, and there was little to alter the RBA’s newly adopted easing bias as it prepares to lower rates. Market expects a 25bp cut in October followed by a similar move in November although the RBA’s strongly worded statement on Tuesday suggests that a cut in September cannot be ruled out.

NZD/USD rallied 40pips following stronger than expected labour data, but unlike its Antipodean neighbour, NZD was unable to sustain those gains and fell back to pre-release levels: Q2 employment surprised to the upside at 1.2%, though the more important unemployment rate for Q2 accelerated to 3.9% from a revised 3.7% in Q1.

1 - 3 Month Outlook:

USD suffered staggering body blows in July with the collapse of IndyMac, the third largest banking failure in US history, and a near-death experience by mortgage giants Fannie Mae and Freddie Mac. USD wobbled and net USD shorts did increase, but USD did not test the March 17 low of 70.7. Its resiliency lends support to the view that USD bottomed in Q1. With confidence unstable, USD might struggle to show steady gains over the next 1-3 months, but it is poised to advance.

The response by Congress and the Administration to the Fannie Mae and Freddie Mac crisis suggests that concerns about systemic stability have peaked. Even so, more bank failures are likely, as the struggle of the US housing sector will continue to weigh on the financial sector, and household balance sheets. Signs of tentative stability in housing are just that, tentative. Delinquencies are still rising, an inventory overhang lingers that will weigh on house prices, mortgage rates have increased and credit standards have tightened sharply. These factors, along with still elevated energy prices, are key elements of the Fed’s concerns about growth over the next few quarters, and might blunt a USD recovery in the months ahead. They will also feature prominently in the Presidential election campaign.

There was one dissenter to the Fed’s August 5 decision to leave rates unchanged, Dallas’ Fisher. Philly’s Plosser, who had argued the need to hike rates “sooner rather than later” to fight inflation and defend Fed credibility voted with the majority suggesting there is little appetite to hike rates anytime soon. Oil’s retreat from US$147.3/b in mid-July to below US$120/b has helped boost US equity markets, and USD and might have helped ease some of the Fed’s “significant concern” about high inflation.

6 - 12 Month Outlook:

In the medium term also, market expects EUR/USD to trend steadily lower, with a mid-2009 target of 1.34. Although this is primarily driven by view that the USD recovery will be well underway in 2009, EUR-specific factors are also negative. In particular, when ECB does finally signal that rates have peaked (Q1 2009), it will also implicitly signal diminishing tolerance of a highly overvalued exchange rate. Market estimates currency suggest EUR/GBP is more than 30% above PPP, a larger misalignment than for any other G10 currency. Technically, prices must pierce 1.4586 in order to present strong evidence that a top is forming.