Foreign Currency Report 12 December 06

USD
The dollar came under renewed pressure after the lift from a stronger than predicted US jobs report last Friday proved fleeting. The beleaguered currency faced sharp swings in the wake of the jobs report rising at first before losing all the ground it covered and then some more. The euro set a new high for the year at 1.3367 USD in the process. It was all change early in the Asian trading session with the dollar again recovering lost ground only to fall back eventually. "We continue to expect the dollar to extend its down trend over the medium term despite the current corrective rebound following the better than expected US non-farm payroll data on Friday," BNP Paribas analysts said in a research note. Steve Pearson at HBOS said the confused price movements suggest a clear-out of technical positions, especially since many investors were holding short dollar positions. "The current move has, in our view, always been as much momentum as macro driven," he said. On the fundamental front, the strong US jobs data led to a scaling back in rate cut expectations. Still, it remains to be seen if this trend will continue.

Several key pieces of US data are due this week, including crucial inflation, retail sales and trade figures. "With markets largely focused on the perceived cyclical divergence between the US and the euro zone, the dollar is most at risk from potentially soft CPI and retail sales data," said Pearson. That aside, markets are also keeping an eye the Fed's rate verdict Tuesday. The Federal Reserve Board's Federal Open Market Committee is widely expected to keep its key federal funds rate at 5.25 pct, where they have been since late June. All eyes will be on the language in the accompanying statement, which is expected to continue to express a greater concern about rising inflation than a slowing economy.

EURO
The Eurozone financial system has strengthened in the past six months, but risks remain from unsustainable world trade and investment patterns, optimistic asset valuations and increased borrowing, the European Central Bank said yesterday. Tighter interest rates could also be a challenge for global financial markets, and the lack of a crisis so far does not mean people can be complacent, the ECB said in its December Financial Stability Review. 'The central scenario for euro area financial stability remains broadly favourable,' ECB Vice-President Lucas Papademos said, presenting the report which is similar to the last review in June. 'The global economy remains robust and is becoming more evenly balanced, and the gradual shift to less accommodative monetary policy is proceeding smoothly,' Papademos continued, adding that he expected this robustness to continue. The report gave an assessment of risks to growth similar to that last given at ECB President Jean-Claude Trichet's December 7 news conference. The ECB broke risks to financial stability down into those from global trade and investment imbalances, from capital markets, from lending to business and households and from banks and insurers themselves. Global financial imbalances, such as the US current account deficit, are very large and likely to continue to increase, albeit at a slower rate than before. 'The prolonged accumulation of expanding US current account deficits has been a source of unease among policymakers,' the report said. If there were geopolitical problems in the oil-exporting countries which fund a large chunk of the US deficit, or if other investors thought it too risky to hold such a big share of their assets in the US, then this could cause widespread falls in asset prices, the report said though the chances of this were rather low, it added. 'In addition, the monetary authorities of countries retaining pegs, or close links, to the US dollar may face the risk of valuation losses on their reserves over the medium-term,' the ECB said. Asked about risks from euro strength and carry trades, where speculators borrow in low-yielding currencies such as the yen and invest in high-yielding ones, Papademos referred to a September statement by the Group of Seven industrialised countries. 'We are in a period when there is some volatility in foreign exchange markets,' Papademos said, saying he did not wish to go beyond the G7 statement, where sharp currency moves were described as undesirable.

GBP
Factory-gate price inflation picked up to 1.8% last month, official data showed today, less than financial markets had expected. The Office for National Statistics said output prices were unchanged in November from October which had the effect of pushing the annual rate up from 1.6% because prices were falling in the same month last year. But "core" output price inflation, which excludes volatile elements like oil, held up at 2.5%, above the 2.1% average of the past year and a figure that may concern the Bank of England "This will boost concerns that core price pressures are mounting," said Jonathan Loynes of Capital Economics. Input price inflation - the cost of raw materials purchased by factories - fell to 2.8%, its lowest since March 2004 but still well above the level analysts had expected. The number was pushed down by a fall in oil prices last month. Separately, the ONS released trade data for October, which showed the goods deficit narrowing to £6.3bn from £6.7bn in September. The deficit for trade with non-EU countries widened slightly to £3.9bn from £3.8bn in September. But the ONS has cautioned that the trade data are heavily distorted by VAT fraud, and policymakers have dismissed their usefulness.

WORTH NOTING!
America's elite banks are expecting sterling to plummet next year after its meteoric rise to near $2 this autumn, believing Britain's growth surge to be well past its sell-by-date. Goldman Sach has advised sophisticated investors take out a "short" position against pound on the derivatives markets as its top trade for 2007, a bet that the currency will fall. "The UK remains the largest current account deficit country in Western Europe, with a substantially overvalued currency about 13pc on a trade-weighted basis," said the bank in a client note. Jens Nordvig, a Goldman Sachs currency strategist, said the credit cycle was turning as the Bank of England finished raising rates, ending the yield premium over European investments that have made UK bonds so attractive. "There are quite a few risks in Britain, especially in the housing market, but this is more a case of Europe doing better rather than the UK falling off a cliff," he said. Lehman Brothers is even more bearish on Britain, warning in its global outlook for 2007 that the glory days of UK dynamism are drawing to a close. It predicted that Britain's FTSE 100 would lag the other major stock markets in 2007, calling for a cut in the UK weighting of global equities from 10pc to 7pc.

The US investment bank also warned that the odds of an outright recession in the US had shortened to 4/1, though it is still betting that the housing slide will bottom out soon enough to ensure a softish "bumpy" landing. Alan Castle, Lehman's UK economist, said the pound would fall to $1.82 in 2007 and to $1.68 by the end of 2008 as UK Inc gradually goes out of favour. "I'm not saying that things will be terrible, but they will feel much worse," he said. The property boom may continue for a few more months as buyers exploit interest-only mortgages and lax credit offers, but would sputter out in the second half of 2007. He expects interest rates to peak at 5.25pc early next year. "The surprise is that the pound has been so strong. Current account deficits matter over time and we're worried that Britain's deficit could widen to 4pc of GDP in 2008," he said. Sterling has a been favourite choice for global central banks switching reserves out of dollars over the last two years but Lehman Brothers said the effect was "starting to fade". Fresh data from the Office for National Statistics show private investors are now the main foreign buyers of UK gilts.