Foreign Currency Report 15 March 2007

Sterling

Sterling rose broadly yesterday, recovering from an earlier eight-month low versus the Euro in what is currently a jittery market. This volatility is still largely due to investors being torn over whether they should take on risky carry trade positions. Falls in equity markets and concerns about the health of the U.S. economy have led investors reluctant to shoulder the risk of carry trades. Carry trades are often utilised when low-yielding currencies like the yen with interest rates at 0.5% are borrowed to fund purchases of higher yielding currencies including Sterling which currently sits at 5.25%.

As a key beneficiary of carry trades, sterling has been more vulnerable than other currencies to their recent unwinding and this environment makes it very hard to predict what's going to happen in the short-term. "The sterling sell-off has been an over reaction ... and next week might be the occasion for sterling to bounce. We've got retail sales, the (Bank of England) minutes and may be the CPI might nudge a little higher. Maybe that's the best hope for sterling recovery," said Chris Turner, head of FX strategy at ING.

Earlier yesterday Sterling shrugged off a mixed UK jobs market report. Average earnings growth picked up to an annual 4.2 percent in the three months to January. Although this potentially supports the case for more interest rate hikes analysts agreed that it was unlikely to give sterling enough of a boost in the current environment.

US Dollar

The US current account deficit jumped by 8.2% to a record $856.6bn (£444bn) in 2006, official figures have shown. This rise is the fifth consecutive annual increase in the deficit, coming despite a smaller trade imbalance in the final three months of 2006.

Even with the fourth quarter improvement, critics say the soaring deficit for the whole year shows the failure of President Bush's trade policies to protect American workers. They contend that America is going into hock to foreigners at an alarming rate even though they have been more than willing so far to hold American assets in return for sales of televisions, cars and other goods to U.S. consumers. The current account is the broadest measure of trade because it covers not only trade in goods and services but also investment flows between countries. It also represents the amount of U.S. assets that have been transferred into foreign hands to cover the gap between American exports and imports.

A deficit of $856.7 billion in 2006 meant that the United States was borrowing more than $2 billion daily to finance its trade gap. However, Nigel Gault, US economist at Global Insight, said he believed the country's current account deficit had "peaked". "The trends are becoming favourable. Robust export growth, and some cooling in import growth, should keep the deficit down this year," Mr. Gault said.

Euro

The Euro showed strength against a number of currencies yesterday while showing uncertainness against the pound. The Euro rose in particular against the dollar in late morning trading, with the European currency moving to a two week high against its American counterpart. The currency traded as the Euro-Zone announced its industrial output numbers. Euro zone industrial production dropped 0.2% on month in January. On an annual basis, output improved 3.7% versus a revised 4.4% growth registered in the month prior.

Against Sterling, the Euro showed little direction, however it is still at its highest point against the pound since the end of July and if Sterling weakness continues then it may continue to gain, which will ultimately result in the Euro becoming increasingly more expensive to buy.

NZD

New Zealand's dollar rose on speculation consumer demand is increasing fast enough to buoy inflation, adding to the prospect the central bank will raise its benchmark interest rate as soon as next month.
The nation's households must show less exuberance over the amount of ``cheap money'' flowing into the economy, Reserve Bank Governor Alan Bollard said in a speech to the Wellington Chamber of Commerce yesterday. At his monetary policy statement on March 8th, Bollard said housing demand added to the possibility of further rate increases.

``The Reserve Bank's underlying concern is still the housing market which indicates they'll probably tighten rates again,'' Danica Hampton, currency strategist at Bank of New Zealand Ltd. in Wellington said. ``Rate hikes attract people to the kiwi dollar.'' If this is the case then that further rate hike will mean that the New Zealand Dollar will strengthen against Sterling and become more expensive to buy going forward.