China scraps its dollar peg

Euro

In a week full of surprises and tests, the dollar failed to sustain a clear direction against its major counterparts. The greenback shined against its rivals at the beginning of the week, however, failed to turn victorious.

The dollar kicked off this week on a strong tone versus the euro supported by upbeat U.S. economic data and expectations that Federal Reserve Chairman Alan Greenspan would signal more U.S. rate rises.

The dollar slipped versus the euro after U.S. capital flows data showed foreign investors' appetite for U.S. stocks had waned in May. The Treasury International Capital (TIC) report showed foreigners sold a net $72 million of equities in May after they bought a net $4.67 billion in the previous month.

It was the first time foreigners were net sellers of U.S. shares since September 2004. Following the capital flows data, markets were cautious ahead of the testimony on the economy by U.S. Federal Reserve Chairman Alan Greenspan. The dollar started to march higher after remarks by Greenspan that although soaring oil prices have hampered U.S. economic growth, the economy was coping well and set to expand at a moderate pace.

Many in the market expect the Fed to raise rates to 4 percent by year-end. But some analysts said the dollar could struggle to post further gains in the near term after rallying around 10 percent against a basket of six major currencies in the past four months.

As the week progressed, positive news on the German economy failed to dent the dollar's gains against the euro. The closely watched ZEW index of German investor confidence hit a 9-month high in July but the surprisingly robust reading was not enough to dispel concerns about Europe's largest economy.

The euro was boosted against the dollar following news that China was going to begin pegging its currency to a basket of trade-weighted currencies, thus increasing the need for China to hold more reserves in euros and less in dollars. In addition the dollar came under renewed pressure ahead of Greenspan's second testimony before the Senate.

The dollar continued to drop against the euro in a rebound from gains, which came in the wake of hawkish comments from US Federal Reserve chairman Alan Greenspan.

Greenspan's confirmation that US interest rates will continue rising initially propelled the dollar before it succumbed to profit taking, with euro being the main beneficiary.

As the week ended, the dollar rally turned into sharp weakness as China revalued its currency. The People's Bank of China (PBoC) said that it has scrapped the yuan peg to the US dollar and re-pegged the Chinese unit to a basket of trade-weighted currencies.

This has effectively caused a revaluation of the yuan against the dollar to 8.11 from its previous value of 8.28.

Range for this week: $1.2000-$1.2300

Japanese Yen

With a public holiday in Japan at the start of the week, yen activity levels were down to a minimum, limiting the currency's trading range.

The yen has been stuck in a tight range around 112 per dollar, supported by renewed speculation that China could revalue the yuan and the Bank of Japan's view that weakness in the economy was receding.Ubeat comments from Federal Reserve chairman Alan Greenspan helped the dollar to creep on the news, with the yen hitting 14-month lows.

Meanwhile, high oil prices continued to batter the yen. Sentiment was also dented by a report in a Japanese newspaper suggesting that if even inflation moves into positive territory, the BoJ will be nervous of changing its ultra-loose monetary policy, given the effects of energy prices on the economic recovery.

Japan has to import all of its oil, the currency is typically very sensitive to movements in the oil price. On the other hand, the low-yielding yen has suffered from a slump in demand as investors flock to the dollar due to the interest rate advantage the U.S. currency has over its rivals.

Higher U.S. rates heighten the appeal of dollar-denominated deposits and expectations that the Fed will continue to lift rates to around 4 percent by the end of the year have spurred dollar buying this year.

As the week progressed, the Japanese yen continued hitting new lows against the dollar as it tests resistance at 113. Growing exports and continued investment have caused the Chinese GDP to rise by 9.5% (Y/Y) in the second quarter following an increase of 9.4% in Q1. The yen has failed to react positively as it is becoming mired in domestic political issues.

As the week came to an end, the yen's fortunes were split, as the currency rallied a full yen against the dollar. The dollar was slumped over 2 pct against the yen following news that China has decided to abandon the yuan's eleven year peg to the dollar in favor of one against a basket of trade weighted currencies.

The Japanese yen fell sharply against the dollar, as the initial excitement over the long-awaited currency revaluation subsided as well as fears over a potential Bank of Japan intervention also prevented the yen from strengthening further.

Looking ahead, the Japanese currency faces a series of downside risks in the near term, particularly a vote next month by Japan's upper house on a controversial postal reform bill. Prime Minister Junichiro Koizumi could dissolve Japan's lower house if the bill is voted down, spooking investors away from the yen on worries about political instability.

Range for this week: Y109.65-Y113.50

Sterling

The British pound started off the week down against the dollar, continuing earlier slide as Rightmove reports a fall in house prices in July - the first time in six months.

These additional signs of a slowdown in the UK only increase current speculation that the Bank of England will lower interest rates by at least 25 basis points at its next meeting in early August.

The tragic attack on London by terrorists hampered the sterling pound and added additional impetus for market players to sell pound for euro which became the destination of choice. Adding fuel to fire, the pound fell sharply as completion of the full merger between Royal Dutch and Shell sparked demand for euros from UK fund managers.

The falls in euro/sterling led the pound to fall against other major currencies too, notably the dollar, which has remained strong ahead of Federal Reserve chairman Alan Greenspan's keenly awaited testimony.

As the week progressed, the Sterling fell a full U.S. cent at one stage after minutes from the Bank of England's meeting showed 4 out of 9 policy-setting members voted for an interest rate cut, up from 2 a month ago, cementing expectations for an August rate cut.

Towards the weekend, the Sterling rose temporarily on news of the yuan revaluation and enjoyed a brief rally after retail sales figures for the UK revealed an unexpected surge in UK retail sales in June.

The figures showed that retail sales rose by 1.3 pct from May, the largest monthly rise since December 2003 and way in excess of expectations, with the market consensus calling for a rise of just 0.3 pct.

The pound fell as worries over terrorism in London intensified following fears of further terrorist attacks after three underground stations were closed due to a security alert and news that police shot a suicide bomber.

Weak second quarter GDP figures which showed the annual rate falling to 1.7 pct, it's lowest since 1993, also contributed to the pound weakness.

With markets still jittery about additional bombings in the UK, coupled with the fact that the US remains on track to continue increasing interest rates while there is strong speculation that the Bank of England will cut rates in August, sterling bearishness remains firmly entrenched.

Range for this week: $1.7350-$1.7700