Foreign Currency Report 16 April 2007

Currency markets respond to the weekends G7 summit as normal play looks set to resume.

This weekends meeting in Washington has seen the the G7 (Group of Seven) repeat precisely what finance ministers had said about exchange rates in Essen, Germany, two months ago. They again said currencies should "reflect economic fundamentals," described disorderly market movements as "undesirable" and called for countries with "large and growing current account surpluses, especially China" to allow movement in their real effective exchange rate.

Chiefs from the world's leading industrial nations also say however that world growth will remain firm despite some risks. They believe that economic growth will hold steady, with the US economy solid despite moderating demand, and the Euro zone remaining healthy. The International Monetary Fund (IMF) forecasts predict global growth of 4.9% in 2007 and 2008. "Although risks remain, the global economy is having its strongest sustained expansion in more than 30 years and is becoming more balanced," the central bank presidents and finance ministers said in a joint statement.

The decision by the Group of Seven leading industrialized nations to make no changes to their views on currency issues leaves foreign exchange markets braced for more of the same in the coming weeks. The likelihood in the short-term is that we will see a continuation of Euro strength as well as U.S. dollar declines. Ministers also made no explicit comment with regards to carry trades, where investors borrow in low-yielding currencies, like the yen or the Swiss franc, to buy higher yielding assets.

Alan Ruskin, chief international strategist at RBS Greenwich Capital in Greenwich, Conn said that comments on the carry trade by senior G7 officials at the end of February's meeting stirred "up a little bit of volatility'. 'I think there was a perceived green light in favor for the carry trade going into the meeting. Now, the light stays green," he said. This would suggest that currencies with higher interest rates such as the New Zealand dollar may continue to strengthen in the coming months.

This news will also increase potential for Sterling as an attractive destination for the carry trade, especially if rates are to be increased in the coming months. Interest rate futures are now pricing in a roughly 80 percent chance of a hike to 5.5 percent at the Bank of England's next meeting in May, which would take the UK benchmark rate above the U.S. one. This news has allowed Sterling to hit a 2-1/2 month high against the dollar although that was partly due to recent data showing tame producer price pressures stemming from the US. This could also lead to a change in investors moving money into the pound that would normally look to the dollar as their safe bet; as a result we are perhaps looking at a perfect time for anybody looking to use Sterling in order to buy US Dollars.

A host of U.S. data is also due this week which will open the way for the Euro to test its 2004 high versus the dollar. The pressured dollar enters the new week facing a slew of U.S. data. The market will digest a March retail sales report, an April manufacturing report from the New York region, and a February report on net foreign purchases of U.S. securities. It will also face fresh comments today from a host of central bank speakers, including the ECB's Jean Claude Trichet and three U.S. Federal Reserve speakers.

The Euro ended last week just one cent shy of its high versus the Dollar thanks to signals from the European Central Bank that it plans to raise rates in June and perhaps again after that. Analysts continue to believe that the single currency will remain in the ascendancy. If this is the case then the Euro will strengthen over the coming months and become more expensive for anybody looking to buy Euros subsidised by most other major currencies.

The one release of the week that could reverse or at least temper the decline in the dollar is tomorrow's consumer price index data. Should March core prices - those excluding food and energy - remain even with the previous month's year-over-year advance of 2.7%, or even increase, that could "temporarily reverse the dollar's weakness," said Matthew Strauss, senior currency strategist at RBC Capital Markets.

The outlook for Sterling against the two major currencies differs in that we are seeing the pound strengthen versus the dollar and potentially weaken against the Euro.