Bob's Currency Focus 16:00 GMT

EUR/USD
The dollar suffered a double blow yesterday 1) when ECB President Jean Claude Trichet delivered a more hawkish statement than the market had anticipated and 2) when Fed Chairman Ben Bernanke signalled the Fed is prepared to take “substantive action” to offset against the downside risks to growth, indicating the Fed would cut rates aggressively. Markets now expect a 50 basis point cut when the FOMC meets at the end of this month. Although inflation is a significant issue in both jurisdictions (headline inflation is in fact higher in the US than in the Eurozone), the two Central Banks have very differing views with the Fed is set to gamble on inflation in an attempt to cushion the effects of the credit crisis and to try and stimulate growth, while the ECB is adopting a wait and see policy. For most currency traders this appears on the face of it to be a no-brainer, i.e. rate differentials are going to very much favour the euro, so the obvious thing to do is to buy the euro against the greenback. The problem is that the market may at any point decide the ECB is wrong and once market doubts begin to mushroom about the sustainability of eurozone growth, the euro will come under increasing pressure. This penny may however take some time to drop. The euro now has the advantage in terms of sentiment and it quickly needs to push its advantage home, if it is to take the coveted 1.50 price handle. We could see a strike at that level next week. An early break above 1.4822 is required to retain the current momentum, otherwise we are likely to see an early retracement back to 1.4640 early next week. In economic data today, the US trade deficit widened to $63.12 in November, primarily owing to a major increase in petroleum prices. US import prices were flat in December, but imported inflation in 2007 as a whole reached a record level and Fed watchers will be monitoring next week’s consumer price data very closely, to ascertain just how much wriggle room the Fed actually has in terms of delivering further rate cuts. For now the euro will probably hold its position into the weekend and traders will hope for a push towards the lifetime high at 1.4966 next week. Traders need to be on the lookout Monday as there is always the possibility of a major injection of funds into the dollar if fears over a sharper global slowdown intensify. For now I do not see any value in buying the euro at the current price. There is value in selling though with a S/L placed above 1.4840, but one is doing so in the knowledge that this is a value trade only that it runs contrary to current market sentiment and assumed direction. Strategy: Sell down on prices around 1.48 once 1.4822 holds, with S/L above 1.4840. Target 1.4680, then 1.4645.

GBP
Cable may be trading Friday at the same levels at which it opened Thursday, but essentially the currency was the big loser yesterday as it failed to bounce after the Bank of England kept interest rates on hold. The market began pricing in a cut from the end of last week but traders have not rushed into removing those shorts thus far. One must suspect the Bank of England know something we do not and we need to note they would have had access to December’s consumer price data before delivering their decision, so it could be that we will see an upside surprise in the UK inflation rate, when the data is released officially next Tuesday. It will be dangerous to back against sterling between now and then particularly given the currency is grossly oversold across the board. I am very much a sterling bear but I don’t see any value in selling at current prices against the euro, dollar or swiss franc. I do expect to see some limited correction next week, after which time we may well enter the market again. The euro in particular has appreciated too much too soon against the UK currency and there must be room for a return to 0.74 at least, before the next leg up. Strategy: Wait for cable to rise to 1.9750 and sell at prices around or above this level with a S/L above 1.9850. Downside price targets are 1.9660, 1.9550 and 1.95.

Yen
The yen has benefited from a fresh bout of risk aversion as stocks dipped across the globe Friday amid fresh credit concerns and fears of a wider economic recession. Fed Chairman’s Ben Bernanke’s commitment to cut interest rates failed to trigger a rally in Japan overnight where the Nikkei plummeted to a 2-year low. The yen has appreciated against the dollar, having pushed the greenback back to below 109, but the move is unconvincing and a late rally in stocks this evening could trigger a broader retreat for the Japanese currency. The euro did reach 162.27 against the yen late Wednesday evening but fell back to below 161, before recovering to 161.35. In economic data, bank lending in Japan was up a mild 0.2% on the year in December, easing from a 0.7% gain in November, while the Economy Watcher’s Survey reported increased pessimism about both the current health of economy and the outlook for the next 12 months, amongst small business owners. The Japanese economy is stuttering along right now and the only reason the currency is gaining in value is because growth concerns elsewhere are leading to a repatriation of funds back into Japan. Any sustained rally in stocks is likely to see risk tolerance levels rise and see both the dollar and the euro appreciate against the Japanese currency. My preferred buy is the EUR/JPY pair, although traders probably need to curtail their profit ambitions, given the wider uncertainty that is currently driving markets. Carry traders have been very brave in recent days with the high yielding Australian and New Zealand dollars attracting very strong support. If these new carry positions should unravel in the coming days, they will lead to a higher appreciation of the yen. Strategy: Buy EUR/JPY on prices close to 160.50 with initial upside target of 162, followed by 163. Employ a S/L just below 160.

CAD
December’s employment report released today showed Canada lost jobs in December for the first time in 8 months. The economy shed nearly 19,000 jobs while markets were expecting a gain of 15,000. The report is meaningful because it came on the foot of a sequence of weak economic reports out of Canada over the past month and suggests the world’s eight biggest economy may be infected by the ails of its larger neighbour and that Canada, as well as the US, is facing a difficult year ahead. One bright light is the fact the unemployment rate remain unchanged at 5.9% while wages grew at their fastest pace for 10 years, highlighting just how tight the labour market in Canada had become. The decline in employment though is likely to raise alarm bells within the Bank of Canada about the economic outlook and with inflation not a deterrent at the moment, a rate cut from the Central Bank on January 22 looks a near certainty. There was better news for the loonie when the Trade surplus for November widened higher than expected and exports rose for the first time since July (up 3%). This report helped stabilise the loonie and prevented the dollar from taking out the key 1.0222 resistance level, which has held since last September. If you followed my advice of recent days, you should have exited with handsome gains. 1.0222 is now a key barrier for the loonie and if the greenback breaks significantly above this level, 1.03 should be hit very soon and parity may well fade in the mirror behind us. Strategy: Buy on any dips back towards 1.0090 with upside targets of 1.02, 1.0220 and 1.03. Those who are in on the longer-run should hold the positions and wait for 1.05. We will move our stop towards parity, once 1.0222 is firmly behind us.


Bob B

Bob's Currency Analysis - 16:00 GMT

EUR/USD
The euro rallied strongly following the ECB’s Press Conference, after ECB President Jean Claude Trichet clearly indicated the Central Bank was still in a tightening policy mode, although rates were again left on hold at 4.0% Thursday. The ECB highlight heightened inflation risks and price stability and warned it would act (by hiking interest rates) to quickly bring prices under control, if and when required. Headline inflation is running at 3.1% in the euro area as against 4.3% in the US, but the two respective Central Banks have very differing monetary policies right now. While the ECB are threatening to hike interest rates, the Fed are currently in the middle of an easing cycle and with the Fed it’s not so much a question of can they cut, rather than by how much? The euro has attracted strong support following the ECB statement and has risen to a new lifetime high of 0.7530 against the pound while rising to 1.4750 against the dollar. The ECB has little concern about a strong euro as the currency issue was not even mentioned in Mr Trichet’s statement. The ECB is essentially leaving it to the Fed to appease financial markets and markets will be studying Ben Bernanke’s speech at 18:00GMT this evening for clues as to how the Fed might act when its monetary policy committee meets later this month. Today’s developments have quashed hopes that the ECB might soften its tone and create the prospect of a future rate cute. Rate cuts in the euro area are a long way off, if we are to believe Mr Trichet and his colleagues. While the euro looks very much inflated in value, few will want to back the dollar against it with a further Fed rate cut imminent at the end of January, a cut which could stretch to 50 basis points. It now seems that if the euro is to breach the 1.50 price barrier, it will do so in the near-term, most probably by the first week in February, if at all. The next upside target for the euro is the 1.4820 price level reached briefly last Friday. Any sustained break above 1.48 is going to require a rethink by many pundits whom believed the euro had already peaked (1.4966 in Nov last). Ben Bernanke could pose further problems for the dollar tonight if he chooses to signal how the Fed may act on rates when the FOMC meets later this month. The Fed has proven itself to be the weakest link of the major Central Banks in terms of capitulating to market demands and with Bernanke at the end of November having already broken from a strict policy of keeping the FOMC’s meeting intentions to itself, don’t be surprised if the Fed Chairman lets something out of the hat this evening. Strategy: no value in buying euro at current prices until there is a significant dip and given the downside dollar risk from Bernanke’s speech this evening, it is best to stay out of EUR/USD for the remainder of today.

GBP
The Bank of England surprised many, including me, by deciding to ignore market demands and to keep interest rates on hold at 5.0%. We won’t find out how close the decision was or what reasons were given to wait, until the minutes of the meeting are released in two weeks time. Sterling has done disastrously following the announcement, with most sterling short positions staying in the market and being added to by new short positions from traders whom now seem absolutely confident that a rate cut is coming in February. If any of the MPC members believed waiting would take some pressure off the currency, which in turn would help temper inflation, they got it badly wrong. Sterling would have done better had the Bank cut rates today as many would then believe rates would remain on hold until March at least. What is obvious, and by consequence deeply worrying for the Bank’s calamity-prone Governor Mervyn King, is that markets believe the Bank of England got it glaringly wrong. The UK’s headline inflation rate at 2.1%, is less than half of that in the US (4.3%), where rates have been cut by 100 basis points since September and are expected to be cut by perhaps a further 50 basis points at the end of this month. I suspect the Governor of the Bank of England himself did not wish to cut this month as he has always been one of the more hawkish members of the Committee. Sterling has fallen to an all-time low against the euro Thursday, the euro rising to as high as 0.7537 and with the rate differential outlook over the coming months very firmly in favour of the euro, one must fear for the UK currency. The euro reaching 80 pence is now a very real prospect. In saying that, sterling is massively oversold at present and some form of limited correction is due. A correction may potentially be triggered tomorrow if UK Industrial Production numbers for November prove to be very positive. I remain a committed sterling bear though, so I will wait to sell sterling at a more attractive price, i.e. upon failed pound rallies. There is little value in selling the currency at current prices. A significant bounce in equity markets could give sterling a temporary and much-needed bounce against the yen and the Swiss franc, currencies against which it has plummeted in the past couple of weeks. Strategy: Wait for rebound in cable and sell at prices between 1.9750 and 1.9850. We need to see a substantial correction in EUR/GBP before contemplating buying this pair.

Yen
Despite a strong late rally on Wall Street Wednesday, Asian stocks plummeted overnight thanks partly to a report from Goldman Sachs that raised the prospects of a recession in Japan. The euro did still gain over 130 pips from the time of our report Wednesday, peaking at 161.82, before retreating to 161.20 at the time of print, with stocks again under pressure Thursday. The yen has gained half a percent on the dollar today and where it ends this evening is very much dependent on the performance of US stocks into the close. If Ben Bernanke says something in his speech this evening that sends stocks higher, the yen will be sold off into the close and the dollar might return to Y110, while the euro should be able to head into the Asian session around the Y162 price level. Japan’s leading indicator for November came in at a lowly 10 points, a long way short of the 50 point boom or bust level. The reading means the Japanese economy may struggle to perform in the 6 months from Nov 2007. The fate of the country’s currency remains dependent on broader market sentiment and risk tolerance levels and any sustained rally in global stocks will see the yen retreat across the board. Key to the direction of the yen into Friday will be Bernanke’s speech this evening and its impact on Wall Street and Asian markets tonight. If Bernanke says nothing to appease market concerns and stocks continue their downward spiral, the yen could potentially push the euro back towards the pivotal Y160 price level and push the dollar back to Y108.50. I’m still inclined to hold EUR/JPY, as stocks are due a further rally and we might wait for Y163. Strategy: Buy EUR/JPY on dips towards Y160.50 with limit prices of Y162 and Y163.

CAD
The loonie came under pressure earlier this afternoon when November’s Building Permits report followed yesterday’s Housing Starts report and disappointed on the downside. In fact USD/CAD has been trading erratically all day ranging from 1.0040 to 1.0150 with the momentum residing with bulls, following yesterday’s key break above 1.0080. Our next upside target is 1.0190, once 1.0150 gives way and then 1.0225. Once convincingly above 1.0225, the greenback should be well on its way to 1.05. The loonie has plummeted against the euro Thursday as the single currency rallied sharply across the board. EUR/CAD is now just shy of 1.50, a mark it hit briefly just after the Bank of Canada cut interest rates back in early December. Tomorrow is a critical day for the loonie with December’s employment report and November's Trade Balance both due for release. Recent data out of Canada has been soft and a negative employment number tomorrow could see the currency hammered, while a strong report will offer some respite, which should prove to be only temporary. There is potential for the employment figure to surprise to the downside as the IVEY PMI last Friday reported a sharp drop in the employment component for December. A key data element to also look at tomorrow is November’s exports % change over October and if this number reports a sharp fall, this too will spell trouble for the loonie’s outlook. Strategy: People who are long on USD/CAD for the longer haul should not fret and simply ride out tomorrow’s data (maintain S/L at 0.97) and wait for price to reach 1.05, while those looking to enter now are best advised to buy on any dips back towards 1.0030 ahead of Friday’s data, with upside price targets of 1.0140, 1.0190 and 1.0220. Otherwise wait until after the employment report, due out at 12:00GMT Friday. A strong employment report (+30K jobs and unemployment unchanged) could potentially see a pullback in USD/CAD to 0.9950, but this in turn will attract new bids at a better price.


Bob B

Bob's Currency Analysis - 18:00 GMT

EUR/USD
The euro came off somewhat against the dollar in trading Wednesday, but the pair remains contained within the 1.4650 to 1.4750 price range. Predominantly negative data out of the euro area this morning kept the euro in check, even though Quarter 3 GDP for the single currency zone was revised up to 0.8% on the quarter, from 0.7%. Quarter 3 GDP however is ancient history at this point and has little bearing on present events. German retail sales fell a disappointing 1.3% in December, having fallen by a revised 2.3% in November and this data only serves to highlight the fact that consumer spending in the euro area is largely depressed at present. To cap a mostly depressing day for German data, industrial production output in November is reported to have dropped by 0.9%, with the manufacturing output component also falling by 0.9%. Germany’s trade balance in November did widen to €19.3B, but France reported a trade deficit of €4.8B in the same month. The softer data is unlikely to have much of an impact on the ECB, which is expected to relay the familiar mantra tomorrow about concerns on price stability and inflation. This will protect the euro in the short-term, although if the ECB surprise and offer a more sobering dovish assessment Thursday, the euro will come under serious pressure. There is no US data out today but the current spikes in oil and gold prices (fuelled primarily by itchy hedge fund investments) will keep the dollar on the defensive for now. The growing probability of a US recession and sharper than expected global slowdown could lead to a sharp fall in commodity prices at any time, once the consequences of what a major slowdown means for industrial resources finally sinks in. A sudden fall in commodity prices could potentially trigger a sharp appreciation in the dollar. For now it is best to await the ECB before venturing in on EUR/USD. Strategy: Wait until after the ECB Press Conference (Jan 10 - 13:30 GMT).

GBP
Sterling fell by more than I would have expected Wednesday with the currency being abandoned ahead of a key rate announcement by the Bank of England this Thursday. The Nationwide Consumer confidence survey dipped to its lowest level since last February in December while the BRC shop price index for December reported a mere 1% annual increase in prices in December. Recent soft data has increased speculation of a Bank of England rate cut tomorrow and I put the chances at 70:30 in favour of a cut. The pound has sold off very heavily in the past week and caution is required because all the technical charts show the currency as significantly oversold, primarily against the dollar and the euro. 1.98 was a good price to enter the market on cable yesterday and anyone short on sterling at the moment needs to remember sterling took a bounce after the last cut in December and a similar occurrence is possible tomorrow, given a cut is effectively fully priced into the market. If the Bank of England does not cut rates, expect a strong rebound for sterling, while in the unlikely event of a shock 50 basis points reduction tomorrow, expect cable to fall to 1.93 before the end of the week. The euro offers no value at current price levels against sterling and indeed the euro could sell off significantly against the British currency on Thursday, if the ECB come out more dovish than anticipated, even if the Bank of England does cut UK rates by 0.25%. Strategy: Wait for bounce in cable and sell at prices above 1.9750 with limit price of 1.9550. Wait until after Bank of England announcement and stay out of market if rates are kept on hold Thursday. We will reassess EUR/GBP after both Central Bank events tomorrow.

Yen
The yen retreated modestly today despite the fact European stocks closed sharply lower and Wall Street again stutters along. There was a sell-off overnight when Asian stocks rallied against the odds, following a sharp decline on Wall Street Tuesday evening. There is particular unease at the yen’s recent appreciation in some quarters and Japanese exporters are stepping in to sell the currency. The euro fell to Y160 late Tuesday, before bouncing to Y161.50 this morning, but the euro has since struggled and the pair is trading at Y160.50 at 18:00 GMT. A decisive break below Y160 could prove important and could lead to a more dramatic sell-off of EUR/JPY positions, especially if there is a dovish sounding ECB on Thursday. The yen is down 0.35% against the dollar Thursday, but is well positioned to send the dollar back towards 108.50 if risk aversion levels intensify later this evening. There was no economic data out of Japan overnight and the Japanese currency’s direction this week will be determined by risk tolerance levels and events surrounding both European Central Banks on Thursday. A rate cut from the Bank of England and a dovish ECB could spark a rally in stock markets and lead to a broad-based sell-off of the yen. The Japanese currency is currently overbought against the dollar and offers no value against it and the wiser strategy might be to wait and then sell the yen against the euro and dollar once stock markets settle and risk tolerance levels climb. Strategy: If Wall Street closes higher (Dow up by more than 0.5%) Wednesday, buy EUR/JPY and set limit price of Y163. Otherwise wait.

CAD
The loonie remains our favourite sell and we are concentrating solely on USD/CAD, which to our mind has the greatest upside potential of any of the major currency pairs in the coming months. The greenback has managed to break above the key 1.0080 resistance level Wednesday and needs to close above this price today if the upside momentum is to gather pace. Canadian Housing Starts in December fell rather sharply but this probably has more to do with intemperate weather conditions than anything more meaningful. The key data for the loonie this week comes on Friday with December’s Employment Report and November’s Trade Balance both due for release. The loonie has been protected this week by stubbornly high commodity prices but comments yesterday from the Bank of Canada that downside risks to inflation have risen in recent weeks has served notice that the Bank of Canada has scope to cut interest rates when they meet in a fortnight’s time. If you followed my advice yesterday, you should have got out with close to an 80 pip gain if you exited at 1.0060. If you have stayed in, I would be inclined to take profits at the 1.0130 price, ahead of 1.0190 and 1.0220. Buy on any dips below 1.0030. If in for the long-term, keep S/L at 0.97 and our ultimate longer-run price target remains 1.05 for now.



Bob B - Jan 9

Bob's Currency Analysis

Bob’s Currency Analysis
We’re finally back to something approaching normality after the holiday break and I hope those of you that dabbled in the market during the notoriously thin trading conditions at year end did not get stung. We witnessed something of an aggressive dollar sell-off against the euro as traders squared positions ahead of the New Year and persistently weak data continues to keep the greenback on the defensive.

EUR/USD
The pair is largely unchanged today, trading within a narrow 1.4680 to 1.4740 band. Retail Sales data out of the eurozone for November was again disappointing, recording a 0.5% decline on the month and 1.4% decline on the year but this negative was offset by a strong set of factory orders numbers out of Germany for November, 3.4% up on the month against a 1.5% forecast decline. The only data of significance today is the US pending home sales figure for November, which tends to act as a gauge for actual homes sales figures for the proceeding month. It should not have a huge impact as a flat number is expected, but a sharply negative number could move the market against the dollar. The market is effectively awaiting the ECB on Thursday and with the MPC not expected to shift from its hawkish stance on inflation, the euro is likely to remain well supported before then. We have comments from two fed officials today, Plosser and Rosengren, both of whom are speaking about the economy and Rosengren’s speech in particular needs to be studied closely as he is the one member of the Fed that voted for a 0.5% cut back in December. With stock markets remaining under pressure and the ‘R’ word being banded about freely, markets are beginning to talk up the prospect of a 0.5% rate cut from the Fed at the end of January, particularly as there is no FOMC meeting in February. I would expect us to remain in a 1.4650 to 1.4750 price range for the rest of the day and really do not see any benefit in entering the market in the middle of this range. Any upward spike outside of this band towards 1.48 is likely to attract selling interest and should offer some value. Strategy: Sell EUR/USD on rallies that peak around or above 1.48, with target downside price of 1.4705.

GBP
Sterling rallied strongly this morning, rising to as high as 1.9828, having hit a 5 month low of 1.9652 overnight. We are edging closer to the Bank of England decision on Thursday and while the market consensus is for no change in rates, there is still a reasonable chance the MPC will move to cut rates again this week. I personally believe they will cut this week because the 9-0 vote in December has clearly demonstrated where the Committee is now leaning and following their own dire warnings about the risks to the economy in 2008, followed by a series of weak data reports, there appears little point in the MPC postponing a cut to February. For this reason and given the downside risks to sterling this week, it is foolhardy to back the UK currency. I am 100% bearish on sterling at present and only recommend selling it, at the right price of course. The euro offers no value against the UK currency but cable prices above 1.98 are worth taking, with target limits of 1.97 and even 1.9680 easily achievable. Cable could dip very low this week, possibly to 1.9350, if the Bank of England does cut on Thursday. In economic data news, the BRC retail sales report for December reveals same store sales only rose a paltry 0.3% on Christmas last year, while total retail sales were up a modest 2.3%. The Halifax house price index rather surprisingly records a 1.3% rise in house prices for December but that report runs contrary to all recent reports and should be put down as a blip and ignored. Strategy: Sell cable on prices above 1.98 with initial target of 1.97, followed by 1.9670. As we get closer to Thursday, we will reassess our limit targets.

JPY
The yen declined for the first time this year Monday and today the trend has continued as a modest bounce in stock markets has triggered a new wave of carry trades that has seen the yen used as the funding currency. The yen made a rather exaggerated move to 108.30 last week when market were mostly sleeping and if stock markets stabilise over the next few days, the dollar may appreciate back up to 111Y and the euro to back above Y163. The medium term scenario is more uncertain and heightened caution caused by fears over a US recession could spark a sudden bout of risk aversion that would propel the yen higher at any time. With the possibility of stocks rising over the coming days in anticipation of an aggressive Fed rate cut at the end of this month and the euro likely to remain strong ahead of the ECB on Thursday, the best value trade on the yen is probably to buy EUR/JPY around prices of Y161, setting a target limit of Y163. The best time to enter a yen sell trade at present is after US stock markets have closed, but only if Wall Street has closed higher - the higher the better.

CAD
The loonie has returned to reality in recent days having appreciated by over 4 cents during late December while most traders were away for the holidays. We hope if you were holding longer-term USD/CAD long positions you were not stopped out as price did go as low as 0.9756 in late December. There was no real reason for the move other than a repatriation of funds into Canadian dollars for year end accounts and the underlying fundamentals if anything have moved further against the loonie in the past 2 weeks. Weak economic data that raise the probability of a US recession is not good news for the Canadian economy, which exports 80% of its goods to the US. The loonie is currently being protected by sky-high oil prices but the significance of last Friday’s IVEY purchasing managers index which revealed a contraction in business spending in Canada in December should not be underestimated. Canada’s IVEY PMI does not carry the same weight in terms of importance as the ISM indices in the US, but given the IVEY index covers both the manufacturing and services sectors and is the only reliable monthly business performance survey out of Canada, we have to take it at face value. This week sees the release of December’s employment data on Friday but we know labour is essentially a lagging indicator and may be behind the eight ball in terms of showing where the economy is right now. Of equal importance will be November’s trade balance, also out Friday. The Bank of Canada meet in a fortnight’s time and with real fears over a sharp slowdown in the economy and the Fed already cutting aggressively, the chances must be increasing that the Bank of Canada will cut interest rates again this month. Once the US dollar convincingly breaks back above 1.0140, USD/CAD could quickly find its way to 1.05. Strategy: buy USD/CAD on dips towards 0.9970 with an initial limit price of 1.0060. A break above 1.0080 should see targets upped to 1.0130 and 1.0190. Longer-term long positions should have the stop loss set at 0.97.


Bob B

Market Watch: 2008 Currency Outlook

The US dollar tanked in 2007 as the US dollar index (dollar measured against a basket of currencies) came off by 9%, following an 8% decline in 2006. The steep 2 year move away from the US currency can primarily be explained by a worsening in interest rate differentials between the US and the other major economies, during which time rates were on hold before being cut in the US, while largely rising almost everywhere else. The dollar came off worst against its Canadian counterpart last year (13.45%), followed closely by steep declines against the euro (11.45%) and Australian dollars (11.49%). Declines against the Swiss franc, yen and sterling were more modest, ranging between 4% and 8%. 2007 closed out with the US economy headed into deeper trouble with growth prospects for 2008 dwindling with each new data release. However with 2 year and 3 year US bonds effectively having already priced in a further 1.25% in Fed rate cuts in 2008 and with the global growth picture looking less and less attractive, the dollar’s decline is largely overdone and 2008 could see a significant recovery in the greenback against its major rivals as we see the baton of economic uncertainty passed around to economies in Canada, the UK, Japan and the Eurozone. The flagging greenback has resulted in a major import inflation issue for the US and indeed as we ended 2007 the US had the highest headline inflation rate of any of the major developed countries (4.3%),

The US is now in a period of stagflation already and those whom believe the Fed has a free hand to cut rates at will to stimulate an economy battling against soaring oil and import prices, may need to think again. The Fed’s ability to cut US interest rates this year is dependent on a stronger US dollar, not a weaker one. If the Fed acts outside its primary remit to appease market expectations (by ignoring higher inflation in favour of short-term economic growth and a bounce on Wall Street), the Fed will dig a deeper hole for itself and threaten the longer run stability of the world’s largest economy. An important consideration is that inflation initially began to flag early in 2007 and the core inflation rate continued to ease during the course of the year, but this means that the year on year comparisons in early 2008 will not prove favourable for inflation and with US GDP likely to struggle in the first half of the year, the US economy seems destined for a sustained period of stagflation in the coming months. The Fed will find it difficult to justify an aggressive reduction in interest rates and indeed if it does move aggressively, the FOMC will be taking a major gamble. Lower interest rates will not cure the ills of an economy that has more deep-rooted fundamental issues (such as negative savings rates).

Expectations for aggressive rate cuts may restrain the dollar in the short-term, particularly against the euro and the yen, but looking forward, the more blurred global outlook picture will benefit the dollar and the currency should make some strong gains this year, particularly against the Canadian dollar, and also against sterling with the UK economy likely facing a headwind in 2008. The principal recommendations for the longer run players for this year are to buy USD/CAD and sell GBP/USD, with these pairs having the greatest scope for favourable greenback gains. The euro will begin to lose its invincibility as the year progresses and the wheels may well come off the single currency in the second half of the year as investors begin to place value over rhetoric and actual growth over inflation, so do not be surprised to see EUR/USD end 2008 closer to 1.30, even if we do have a brief period of trading above 1.50 over the opening months of the year.

Euro
The euro did exceptionally well in 2007, ending the year significantly higher against both the dollar and sterling, despite the ECB keeping rates on hold for the second half of the year. With both the Fed and the Bank of England now in an easing cycle and the ECB maintaining a hawkish line, the euro looks to have the most to benefit in the coming months when one looks exclusively at interest rate differentials. But when we start to look closer at economic performance, we see that the US economy grew at twice the rate of the euro economy in quarter 3 of 2007 and while the euro economy may have outperformed the US in quarter 4, the outlook for the euro economy this year is at best uncertain. With credit constraints continuing to curtail European markets and marked evidence of slowing economic growth in the 13-nation zone, in normal circumstances we would expect the ECB to cut interest rates, but instead the Bank are threatening to raise rates because of current inflation rates of 3%. While the US Fed are gambling on softening inflation risk, the ECB takes the opposite view and markets have thus far taken the ECB at its word in terms of how it is pricing the euro. The likelihood however is that the euro economy will cool considerably as the year unfolds and markets will start to move ahead of the ECB in terms of lowering rate expectations and the euro should come under intense selling pressure, particularly against the dollar. There is enormous scope on the downside for the euro if events move against it and with so much bad news already priced into the US currency and the US economy likely to outperform the euro economy as we move later into the year, the dollar could end 2008 around much the same price level as it started 2007, i.e. with EUR/USD trading around the 1.30 mark. The euro will remain strong against sterling and likely reach 0.80 in the first half of the year as UK interest rates are lowered, but if the Bank of England front-ends its rate cuts, sterling should battle back stronger in the second half of the year against the euro. We expect to see the euro fall to 145 against the yen as a sustained period of risk aversion sends the yen higher over the first two quarters, before a euro recovery in the latter half of the year.

Sterling
Sterling is written off by most analysts in 2008, with economic fundamentals having shifted to the soft side and the Bank of England expected to cut rates several times during the course of the year. In recent months the slowing housing sector has begun to have a negative impact on consumer spending while we have also witnessed a marked slowdown in both industrial sectors of the economy (manufacturing and services). UK growth has consistently been above 3% over the past 2 years but could slow to around 1.8% or below this year. The UK economy is very much dependent on the country’s financial sector and with credit restrictions still gripping the economy, the Bank of England will be forced to cut rates just to keep liquidity at palatable levels. The biggest risk to the overall economy in 2008 is likely to come from the housing sector, where negative equity concerns will lead to more difficult credit conditions and more conservative spending by consumers. The housing downturn is not yet a crisis in the UK, like it is in the US, as house supply levels on the UK market have remained remarkably tight. Still, the UK has a significant current account deficit and with incoming Merger and Acquisition funds drying up, sterling may have few friends this year. UK interest rates, at 5.5%, remain high by comparative standards and to stimulate the economy in 2008, we expect the Bank of England to trim rates by as much as 125 basis points. Like in the US, UK interest rates may be falling at a time when inflation is on the rise, but the Bank of England’s primary concern as of now, like that of Fed, appears to be economic growth. Most of the UK rate cuts should come in the first half of the year and this is when sterling will be at its most vulnerable, particularly against the euro and the Swiss franc, where rates are most likely to remain on hold. The euro should hit 80 pence, probably by the second quarter, but we expect the single currency to then come under pressure itself and the pound should be able to curb its losses against the euro in the second half of the year. There is however much more downside potential against the dollar, as we believe the greenback will bounce this year as the economic doubts that plagued the dollar last year spreads more rapidly to Europe, the Far East and the developing countries and we believe this will lead to a major repatriation of funds back into the US dollar. We also expect UK interest rate cuts to exceed those in the US by 50 basis points and see sterling falling to below 1.75 against the dollar, at least, by the final quarter.

Yen
Japan remains an export-dependent economy and domestic demand simply is not there to grow the economy at the levels required to see the country through in the event of a sharp slowdown in the global economy. To make matters worse, the recent appreciation in the yen has forced Japanese exporters to become more competitive as exchange rates reach their most unfavourable level in two and a half years. The yen remains the least responsive of all major currencies to domestic economic data and the fate of the currency this year will very much depend on events elsewhere. We see more upside potential for the yen in the coming months as broader global economic concerns keep risk aversion levels near their highs and scares off investors that would normally fund risky assets through the low-yielding yen. A rebalancing of global capital accounts should result in the repatriation of capital funds back into Japan over the coming months and boost the value of the yen. The huge volume of net yen short positions that existed in the market over the past 12 months has now been eroded and the sudden, massive spikes in appreciation that have become synonymous with the yen in recent years will become less of a factor in 2008. We do see the dollar depreciating to below Y100 probably sooner rather than later, but see limited scope for movement below this level as we don’t see Japanese interest rates moving at all this year, while we expect the Fed to emerge from its easing cycle by Quarter 3. While inflation in Japan is currently running at a multi-year high, it is still only a 0.6% annual rate and it is owed exclusively to imported inflation from higher oil and food prices. This inflation will evaporate when offset against a higher yen and once commodity prices ease, as we expect the will. When the US Fed’s easing cycle is over and rate cuts elsewhere also patter out, we believe renewed interest in carry trades will send the yen back into retreat and indeed by December we expect the dollar to be trading higher against the yen than where it started the year. We see potential for a sharp move downwards in EUR/JPY with the single currency coming under real pressure the further into the year we go and the euro should fall to below Y145, most likely during the middle two quarters.



Bob and Ted

To be continued….