Geopolitical fears continue to dominate

Euro

The U.S. dollar carried over some of its momentum from a week earlier, when it rose on news that non-farm payroll surged in January at the fastest pace in two years. But jitters over possible war in Iraq gnawed its gains.

German Chancellor Gerhard Schroeder and Russian President Vladimir Putin said they hoped Iraq could be disarmed peacefully. Putin said this was also broadly the attitude of France and China, fellow veto wielding members of the UN Security Council.

US President G W Bush, on the other hand, kept up pressure on Iraq and the United Nations, saying that Baghdad must disarm and that the UN Security Council must move quickly or is deemed irrelevant.

The greenback also moved higher after Iraq agreed to unconditional reconnaissance flight over its territory to seek out banned weapons. The dollar remained firm even after White house dismissed the offer, saying "the bottom line" was for Baghdad to disarm.

In Europe, also adding weight to the euro was another set of gloomy German data where industrial productions for December registered its worst fall in four-years. Reports that Germany was preparing the ground at European level to loosen budgetary policies, a move seen by the market as reducing fiscal responsibility also pressured the euro lower.

The European Central Bank said in its monthly bulletin that growth risk in the euro zone remained tilted towards a slowdown, but said that judging economic and monetary policy implication of a war in Iraq is almost impossible. The head of Germany's engineering employer association said there is signs the euro's gains are starting to impact exports because prices become less competitive.

Later in the week, the greenback yielded to downward pressure after Federal Reserve Chairman Alan Greenspan said at the start of his twice-yearly testimony to congress that geopolitical fears were creating "formidable barriers" to US business spending.

Greenspan's testimony was split into two: (1) the economy and (2) fiscal discipline. The fiscal section covered a lot of ground that Greenspan has already covered before, but the new bit was that a stronger economy would not automatically fix the medium term deficit problem.

On the economy, the text spent plenty of time suggesting that growth has been and is continuing to be constrained by the Iraq factor. It is this geo-political risk that has contributed significantly to lower equity values, wider corporate spreads, tightening bank lending standards, and general risk aversion that has dampened business outlays and hiring.

In a sense, it's Saddam's fault that the economy is not growing quicker. The Fed has placed its bets then: the economy will strengthen nicely once Iraq is out of the way. This is Greenspan's "more probable expectation". If this view is right, one could imagine that Fed rate hikes would be back on the agenda towards year-end.

However, the Fed admits it could be wrong. Although unlikely, Greenspan says there is a chance the economy could instead be "laboring under persisting strains and imbalances that have been misidentified as transitory". So once Iraq is out of the way, and if the economy stays weak, Greenspan says, "various initiatives for conventional monetary and fiscal stimulus will move higher on the policy agenda".

Greenspan's comments weighed on US stocks, as did an audio tape broadcast said to be from Osama Bin Laden saying suicide attacks were important in fighting America. That sparked fears of extremist attacks against US interest, spooking the dollar further.

Elsewhere in Europe, Swiss National Bank Chairman Jean-Pierre Roth said the bank could intervene if the rise in the Swiss franc threatened to deflate Switzerland's economy. Roth also said the franc's safe haven status was "more limited than people believe."

By the end of the week, North Korea also ruffled some feathers when a senior official was quoted as saying the country was capable of striking US targets anywhere in the world if provoked. US intelligence officials told the Senate that North Korea was developing missiles capable of hitting the US West Coast, although Pyongyang had not tested the missiles.

The dollar garnered short lived support from January US retail sales report that showed sales excluding automobiles rose 1.3 percent, the fastest gain in two years. The headline number of overall sales fell 0.9 percent last month, off more than the 0.6 percent decline economist expected.

US dollar ended the week on a high note after the United Nations' chief weapon inspector gave a report on Iraq that left the Security Council still divided over the necessity of war. Blix said there was no evidence that Iraq had weapons of mass destruction, and he noted that Baghdad had taken steps to co-operate with his team.

With the focus on UN, the dollar paid little attention to news that US industrial output jumped 0.7 percent in January, boosted by renewed auto production. Economist on average had expected a rise of only 0.3 percent. The dollar did slip modestly after the University of Michigan reported that its preliminary February consumer sentiment index fell to 79.2 from 82.4. Analyst had forecast a reading of 81.2.

Range for the week: $1.0500 - $1.1000

Yen

The week started with Japanese finance official verbally supporting the yen, Zembei Mizoguchi said that Japan was closely watching the foreign exchange market to prevent an overshoot or volatility in exchange rates.

On the economic data front, figures showed Japan's export performance stayed strong in the last month of 2002. But on a bleaker note, bank lending fell for the 61st month in a row and the amount of money in circulation slowed.

That trend has raised calls for the government to replace outgoing Bank of Japan Governor Masaru Hayami with someone who will take more drastic monetary easing steps. Prime Minister Junichiro Koizumi has said he will decide on a new governor around February 20, but top government spokesman said that the new governor might not be named until a Group of Seven meeting on February 21-22.

Japan's economy unexpectedly grew last quarter, easing the threat of a fourth recession in a decade, after a sales surge by automobile makers and other exporters. Gross domestic product expanded 0.5 percent from the third quarter, seasonally adjusted, the Cabinet Office said the economy grew 0.3 percent in 2002 and last shrank in the final two quarters of 2001.

Exports accounted for more than half of growth in the world's No. 2 economy in the three months to Dec. 31, rising 4.5 percent as bottlenecks caused by an October port strike in the U.S. were cleared

Through out the week Japanese yen traded within its tight range of 120.15 to 121.75 as the market was trapped between fears of intervention and rumours of Japanese investors converting income gains made from US treasuries into yen. Such flows come around every year before Japanese fiscal book closing in March.

The Bank of Japan also decided to keep monetary policy unchanged, though the market remains more focussed on any possible shift in policy that may occur once BoJ Governor Hayami steps down later this week.

Range for the week: 119.00 - 124.00

Sterling

Sterling drove higher against the euro in the wake of better-than-expected data on the UK trade deficit, and was also helped by a dollar rebound that put the single currency on the defensive.

The Office for National Statistic said the country suffered a smaller than expected global goods trade deficit in December of 3 billion pounds, well down from November's record 4.1 billion figure. The data also showed Britain's trade deficit with rest of the world hit a hefty 34 billion pounds last year, the worst since records began over 300 years ago, but sterling took heart from the monthly figures.

Mid-week, sterling dropped to a three-week low of $1.6110 on concerns over the UK economy ahead of a Bank of England inflation report due later in the week. After last week's surprise interest rate cut, investors are concerned that the report might show the economy was set for a bigger slow down than initially expected.

Sterling weakened against the dollar and euro after the BoE quarterly inflation report dispelled the worst fear for the UK economy but held out little prospect of great improvement. Sterling breathed a sigh of relief immediately after the much-anticipated report was released, taking comfort from the BoE's assessment that economic growth would remain around trend for now. But it fell afterward as market digested the bank's warning of risk still ahead for the British economy and of a potential consumer and business sentiment downturn linked to the threat of war with Iraq.

On the political front, Chancellor of the Exchequer Gordon Brown said the government would carry out four more studies to assess the economic impact of the euro to complement the five tests the government has committed itself to completing by June.

Range for the week: $1.5900 - 1.6400