The Euro-zone stresses have continued to be the dominant focus over the past week and there will continue to be very important areas of vulnerability which will maintain a high degree of uncertainty over the medium-term Euro outlook with official comments remained under very close scrutiny in the short-term.           

 Key events for the forthcoming week

Dollar: 

The latest US economic data releases have been mixed, but there has been tentative evidence of firmer conditions which will provide some degree of dollar support on hopes for investment inflows and higher yields. There has, however, been no evidence at this stage that the Federal Reserve will draw back from the US$600bn quantitative easing plan and this will limit potential dollar buying. International conditions will be watched very closely and there will certainly be defensive dollar demand at times, especially if Euro fears intensify. Overall, it remains the case that the US currency will be dependent on weakness elsewhere to make much headway.

The dollar advanced against the Euro and strengthened to a two-month high beyond 1.33, but the performance against other currencies was certainly not convincing as markets focussed generally on Euro weakness rather than dollar strength.

The US economic data was mixed and failed to have a decisive impact. Jobless claims were much lower than expected at 407,000 in the latest week from 441,000 previously which was the lowest reading since July 2008. In contrast, there was a sharp decline in durable goods orders and new home sales. There was a dip in existing home sales to an annual rate of 4.43mn from 4.49mn, although the impact was limited.

Minutes from November's FOMC meeting revealed that the Fed also held a conference in mid October to discuss quantitative easing. A plan was proposed to target a rate of the long-term US Treasury bond yield and buy unlimited Treasuries if required to secure this target rate.

From the dollar's perspective, there was relief that this plan was rejected in favour of the US$600bn package as yield targeting could have put the dollar under severe pressure on medium-term inflation fears.

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The promise of an Irish support package has not provided durable relief for the Euro. There will be fears that the domestic political conditions will not be constructive for meeting conditions attached to the package and there will also be fears over a further contagion effect with other member countries coming under attack. Confidence is likely to be very fragile with further speculation that the Euro will not survive in its current form. There will be relief at times, especially if the growth-orientated data can hold firm, but the Euro will find it difficult to gain sustained relief.

Despite an initial relief rally, the Euro remained under pressure for the week as a whole as underlying confidence in Euro-zone markets deteriorated with the currency under widespread pressure with important contagion fears.

After agreeing to negotiate a support package, the Irish government announced a EUR15bn four-year package to curb the budget deficit, but confidence remained very weak, especially with serious doubts over the political ability to deliver such cuts. Standard & Poor's also downgraded Ireland's credit rating by two notches.

There was a further widening in yield spreads while Greek default swaps hit the highest level for four months and there was a poor reception for the latest German bond auction while tensions also increased over Portugal.

The German Finance Minister commented over how serious the situation was and Chancellor Merkel stated that the Euro was in an exceptionally serious situation.

There was also a widening of German-Spanish yield spreads for the eighth successive day as markets continued to fret over the contagion risk. Spain will remain extremely important in the medium term as the Euro-zone members would find it much more difficult to fund any support package for the Spanish economy and there would be very real fears over a Euro break-up in the event of severe pressure on Spanish markets. There was also a further increase in European debt trading margin requirements which undermined Euro sentiment.

There was a significant shift in tone by political and central bank figures later in the week. The French and German governments announced that the existing Euro support mechanisms would remain in place until 2013 as officials aimed to dampen fears that private bond-holders would need to share the burden on any future debt restructuring.

German Chancellor Merkel stated that the Euro will survive while Bundesbank head Weber commented that the Euro was a highly stable currency and not in danger. The comments suggested a coherent attempt to bolster Euro sentiment after the battering seen this week, butt he currency remained under pressure.

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The Korean situation will be watched closely and the Japanese currency will lose support if there is any further military action. Domestically, confidence in the Japanese economy will remain fragile and there will be pressure for yen gains to be resisted. Given an underlying lack of confidence in the dollar and Euro, the yen should still be well placed to avoid substantial selling pressure, especially with potential capital repatriation and the dollar is likely to advance only slowly.

The  dollar spiked higher to above 83.80 against the yen on Tuesday following news of an exchange of artillery fire between North and South Korea. The US currency maintained a generally firm tone during the week, although dollar ranges were relatively narrow.

There were further tensions surrounding the Korean situation with North Korea threatening to declare war over the South's military exercises with the US this weekend. The simmering dispute will remain a negative yen factor, although the impact should be measured unless there is an escalation of the situation.

The trade surplus for October was slightly higher than expected, but there was a further slowdown in exports and the government remained generally pessimistic over the economic outlook.

There was a headline rise in consumer prices in the year to October, primarily due to the impact of higher taxes and there was a continued decline in core prices. There will be continued pressure for yen gains to be resisted.

Sterling:

Monetary policy will remain an extremely important focus in the short-term. There will be further divisions within the Bank of England and market expectations are liable to shift frequently which will also trigger Sterling volatility. The bank is likely to be broadly neutral in the near term, but expectations that a tighter fiscal policy will undermine growth will tend to limit the scope for any strong-buying support. Sterling will gain some protection from the lack of confidence in the Euro, although caution is required as only a small shift in sentiment could trigger very sharp Sterling losses given the underlying debt profile.

Sterling weakened against the dollar for the week as a whole and tested four-week lows against the US currency, although this was a function of dollar gains rather than aggressive Sterling selling and the UK currency pushed to a two-month high beyond 0.8425 against the Euro.

The latest mortgage approvals data was weak with a decline to the lowest level since March 2009 which will maintain fears over the housing sector.  GDP for the third quarter was unrevised at 0.8% which provided some degree of relief, but the impact was limited.

In testimony to the Treasury Select Committee, Bank of England Governor King remained generally cautious over the economic outlook and also stated that a considerable amount of spare capacity within the economy would tend to hold down inflation. King also stated that there could be further quantitative easing if stronger exports failed to offset the impact of subdued domestic demand.

The other MPC members broadly maintained their approach to policy, although Posen did criticise the virtual endorsement of the government's fiscal policies by King.

The generally dovish central bank stance pushed Sterling to lows below 1.5730 against the dollar and it was unable to secure much of a recovery

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International developments are liable to remain dominant in the short-term and the franc will maintain defensive support on a lack of confidence in the Euro-zone. There is also a possibility of much more substantial capital flight away from the Euro into the franc. The National Bank is likely to remain vigilant over the possible threat of deflation, especially as recent inflation data has been weaker than expected. There is, therefore, the possibility of renewed intervention to weaken the Swiss currency.

 The franc maintained a firm tone against the Euro over the week as a whole and tested Euro support below 1.33. With the franc robust on the crosses, the dollar struggled to make much headway, but did probe resistance levels just above parity.

The Euro-zone debt developments will remain an important focus and there is still the potential for defensive franc support on an underlying lack of confidence in the Euro-zone fundamentals. Markets will remain on high alert for comments from National Bank officials if there is any acceleration of franc gains from current levels.

Australian dollar:

The Australian dollar was prone to choppy trading conditions during the week with lows below 0.97 against the US dollar.

The Australian currency was boosted by expectations of reserve diversification into the currency, especially with confidence in the US currency and Euro generally weak. There was also relief that China did not increase interest rates further.

Risk conditions deteriorated at times and domestically there were comments from Reserve Bank Governor Stevens which suggested that interest rates would not increase in the near term and this put downward pressure on the Australian dollar.

The Australian dollar will remain prone to sharp corrections weaker as international risk conditions continue to have an important impact and there are likely to be greater doubts over the economy.

Canadian dollar:

The Canadian dollar found support close to 1.0250 against the US currency during the week and secured a generally firmer tone even though there were wider US gains against the Euro.

There was further market interest in commodity currencies which helped underpin the Canadian dollar. There was also speculation that the Bank of Canada would move back to a policy of raising interest rates on reduced fears that Canada would be harmed by a slowdown in the global economy.

There is likely to be further selling pressure on any renewed move stronger than parity, although the fundamentals suggest that the Canadian dollar will be resilient.

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The rupee remained generally on the defensive during the week and it did retreat to test two-month lows near 45.85 against the US dollar, especially when there was a general deterioration in risk appetite.

Overall losses were still contained and selling pressure was generally limited. There were no signs of substantial capital outflows which helped provide protection for the currency. There was also evidence that exporters were selling the US currency at levels above 45.50 which cushioned the rupee.

The rupee should be able to resist further heavy losses, although it will be difficult to advance far in the very short -term given a more cautious attitude towards risk appetite.  

Hong Kong dollar:

The Hong Kong dollar was unable to make a significant challenge on levels near 7.75 against the US dollar curing the week and dipped sharply to lows beyond 7.7620.

The local currency was undermined by generally weaker risk appetite during the week and also lost support following the North Korean shelling of a South Korean island. Domestically, stronger than expected new regulations on the property sector also undermined interest in the Hong Kong dollar on expectations that medium-term capital flows would be reduced.

The Hong Kong dollar will lose ground when risk appetite deteriorates, but heavy selling pressure is unlikely given medium-term revaluation speculation.

Chinese yuan:

The yuan generally consolidated in the 6.65 area against the US currency during the week with markets struggling for direction.

Following the move to tighten reserve requirements the previous week, there was reduced speculation over an immediate move to increase interest rates, but there was still expectations that the central bank would need to tighten

There was further international pressure for a stronger yuan, although the rhetoric was more moderate, especially with a greater focus on the Euro-zone difficulties.

There will be continuing strong expectations of further yuan appreciation in the medium term, especially with persistent capital inflows. The central bank may find it increasingly difficult to maintain narrow trading ranges.

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