The USD composite index, which measures the value of the USD relative to the world’s major currencies, finished 2005 up 13%, marking the best year for the dollar in almost a decade. The USD might have recorded its best year since 1984 if not for weak housing data, which was released this week.

The data, which indicated sales of new and existing homes both declined in November, could be a harbinger for a downturn in the housing market. Over the last few years, the US economy has remained strong partly due to low interest rates, enabling consumers to borrow against the rising value of their homes. As the Fed has raised interest rates, consumers have predictably borrowed (and spent) less, which could spell trouble for the US economy. The Fed will certainly take this into account when it decides whether to raise interest rates next month. Reuters reports:

“What the market seems to be focusing on are U.S. home sales, which were quite a lot weaker than what people were hoping for. This is definitely weighing on the dollar via what people think that might mean for interest rates.”

Read More: Dollar slips as markets weigh soft US housing data

In an unconventional move, South Korea has announced it will restrict access to real-time forex data to a select group of banks, in order to stem what it has deemed ‘excessive volatility’ in the Korean Won. For years, South Korea has overtly intervened in forex markets in order to maintain a cheap currency. However, as the Won has appreciated nearly 5% in the last three months, South Korea is now turning to a les cut-and-dried method for depreciating its currency. The nation’s Central Bank apparently believes that using delayed forex quotes will limit speculation and increase liquidity. The Korean Herald reports:

Under the new trading system, companies and offshore traders will not be able to access the real time information shared by foreign exchange banks. All the currency transactions among nonbank market participants will be made based on the “reference rate” among foreign exchange banks.

Read More: Seoul to restrict currency trading data to banks

In a recent press conference, the ECB’s representative from Belgium hinted that the ECB is ready to raise interest rates for the second time in as many months. When questioned about current interest rate levels, he stressed that rates cannot remain low forever, much to the chagrin of many EU politicians, who want to be certain the EU economies are on solid footing before the cost of borrowing is increased. The Belgian representative also expressed his confidence in the recent performance of the EU economies, and stated that it was important that the EU continue to keep pace with inflation. Bloomberg News reports:

[His] remarks on interest rates and his upbeat assessment of the economic outlook helped push up the euro from a two-year low against the dollar.

Read More: ECB’s Quaden Says Rates Won’t Stay Put `Eternally

In the beginning of 2005, currency traders and economists alike, predicted the USD would continue its decline against most of the world’s major currencies, due primarily to the burgeoning twin deficits. The USD’s strong performance in the last year, therefore, came as a surprise to many, and proved that even the most astute forex experts are rarely able to make meaningful forecasts. In reflecting on the USD’s upsurge over the last 12 months, currency traders have the benefit of hindsight. As the twin deficits ballooned, central banks predictably decreased their collective purchased of USD-denominated securities. However, private investors more than compensated for this shortfall. The Homestead Act, which offered tax breaks on the repatriation of foreign earnings, combined with an environment of rising interest rates, to further buttress the Dollar. The Financial Times reports:

Warren Buffet went some way to proving his own adage correct this year, sustaining losses on the $20bn or so his investment company, bet on a falling dollar. But [he] is probably not alone in wishing his predictions could be prematurely buried this year.

Read More: Market Insight: Currency markets in 2005

From 2001 to 2004, as the USD slid against most major currencies, the United Arab Emirates (UAE) considered diversifying its foreign exchange reserves into alternative currencies. While the USD’s strong performance in 2005 has relieved the UAE of the sense of urgency it had been feeling, the decision must still be made in the not-too-distant future. In total, the regions that comprise the UAE control over $23 Billion in foreign exchange reserves. While similar countries concentrate their reserves in a Central Bank , the reserves of the UAE are spread over numerous banks and investment agencies, in the form of cash, tradable securities, and private investments, which would significantly inhibit diversification. The Khaleej Times reports:

UAE central bank foreign reserves are held virtually entirely in dollars, but an official said in July the bank was looking to convert five percent of its holdings into euros.

Read More: UAE still weighing option to diversify forex reserves

As 2005 draws to a close, currency traders are taking a collective step back, in order to asses the performance of forex markets. Among the biggest losers, surprisingly, is the South African Rand. Having nearly doubled in value against the USD from 2001 through 2004, the Rand has depreciated 12% against the USD through December. The silver lining, as far as economists and fundamental analysts are concerned, is the marked decrease in volatility surround trading in the Rand, due largely to an increase in liquidity. Rand bulls are already looking to 2006, when GDP growth is expected to exceed 5% on the heels of strong capital inflows and high commodity prices. Reuters reports:

Deepening liquidity also points to growing confidence in an economy which most analysts agree has been well-managed — especially by emerging market and African standards.

Read More: Has S.Africa’s wild rand finally been tamed?

This year, there have been two issues on the minds of currency traders that employ ‘fundamental analysis:’ global imbalances and interest rate differentials. While the last two posts attempted to bring clarity to the role of interest rates in forex markets, this post will explore the effect of widening global imbalances.

The laws of economics imply that a nation experiencing a current account or trade deficit should witness a depreciation in its currency, so as to cheapen its goods and assets in the eyes of foreign consumers and investors, respectively. While the US twin deficits have soared to record levels, however, the USD has appreciated against a broad basket of currencies. The reason, as I have reported on numerous occasions, is tied to the continued willingness of foreigners to invest in the US. But is this phenomenon sustainable?

Some economists have argued that these deficits are a natural outgrowth of globalization and/or a global savings glut; accordingly, they believe the current value of the USD is economically defensible. Other economists have adopted a more cynical outlook, arguing that foreigners’ current penchant for US assets will eventually wane, at which point the USD will plummet. Unfortunately, this is a debate that will not soon be settled, and it may be years before the sustainability or lack thereof of the current global imbalances can be measured.

Read More: US deficits put cloud over outlook for 2006

Yesterday, I reported that Central Banks are becoming more transparent in matters of monetary policy. As if on cue, today the European Central Bank and Bank of England offered separate insight into the directions of their respective interest rates. The ECB hinted that it would likely raise interest rates twice in the next year from the current level of 2.25%, while the Bank of England indicated that a cut in its interest rates would take place in March. The corresponding changes in interest rate differentials should benefit the Euro and hurt the British Pound. Reuters reports:

But some analysts see U.S. rate rises stopping there. The latest report about the ECB is seen as likely to boost the euro. “It’s a reminder that not only the Fed but also the ECB is raising interest rates,” said one currency strategist.

Read More: Euro jumps briefly on rate speculation, pound down

The principle of interest rate parity dictates that exchange rates and interest rates should move in opposite directions. In addition, when a country raises interest rates, it often experiences a surge in capital inflows, from investors who wish to earn higher risk-free returns. Likewise, currency traders and economists keep a close watch on interest rate levels, which often precede movements in forex markets. Fortunately, it seems central banks, which set short-term interest rates in most countries, are becoming more transparent. According to a new study, in the last decade, every major central bank has become progressively more open about its intentions for monetary policy, including inflation targets. In theory at least, currency traders should be able to count on central banks to unwittingly provide clues on the direction of currencies. The Economist reports:

The Fed, for instance, has been publishing minutes of its meetings more speedily since the start of this year. Ben Bernanke, the Fed’s chairman-designate, favours an explicit inflation target.

Read More: The end of surprises

In the last few weeks, the Japanese Yen has appreciated 4% against the USD, prompting officials from Japan’s Ministry of Finance to declare that they will be monitoring the Yen closely for unnatural fluctuations. The announcement was widely interpreted as a hint that the Ministry would intervene in forex markets and prevent the Yen from appreciating further. American industry lobbyists, in turn, responded with a show of outrage, urging US trade officials to prevent Japan from tampering with the value of the Yen. The Jiji Press reports:

Noting that Japan for years has massively intervened in currency markets to keep the value of the yen “artificially low,” he said, “Japan’s currency manipulation is a serious and damaging unfair trade practice that is causing permanent harm to the industrial core of the U.S. economy.”

Read More: U.S. Auto Official Raps Japan for Trying to Stop Yen Rise

Several weeks ago, Chinese officials suddenly announced they had reason to believe China’s economy is much larger than past GDP figures indicate, and they immediately began amassing data and building models to prove their point. Yesterday, the same group of officials released a revised set of GDP figures, which raised the value of China’s economy by 17% and catapulted the country into 6th place in global nominal GDP rankings. Apparently, past GDP calculations had grossly underestimated the size of China’s booming service sector, which represents 41% of China’s economy. In addition, the new GDP figures reveal that fixed asset investment is actually at a sustainable level. In short, China’s economy is both larger and more structurally sound than previously believed. The Financial Times reports:

The new, more rosy picture of economic strength could fuel calls from the US for China to revalue significantly its currency, which critics say is being held at a level that grants an unfair trade advantage.

Read More: China revises size of economy up by 17%

The US Federal Reserve Bank is currently in the process of raising interest rates. Meanwhile, the European Central Bank and Bank of Japan are preparing to begin implementing tighter monetary policies at unknown dates in the short term. The Bank of England, however, is moving in the opposite direction, having recently announced that it may cut rates in the first half of 2006. The Bank of England is caught in the unenviable position of trying to simultaneously manage a housing bubble, rising inflation, and slowing growth. Previously, Britain’s Central Bank had prioritized housing and price stability. This latest announcement, however, represents a change in tack. As investors price in the possibility of multiple rate hikes, the UK Sterling should add to its 6% decline against the USD so far this year. Bloomberg News reports:

“The market was always complacent about the performance of the U.K. economy,” said a currency strategist at Royal Bank of Scotland. “Comments…play into the hands of a bad performance for sterling against the dollar next year.”

Read More: Pound Drops, U.K. Bonds Rise as Bean Hints First-Half Rate Cut

When a nation runs a current account or trade deficit, the laws of economics dictate the value of that nation’s currency should depreciate proportionately to make its products and assets relatively cheaper for foreigners to buy. However, as the US twin deficits have exploded over the past few years, the USD has remained stable or appreciated against all major currencies. The explanation seems to be that foreigners are still more than willing to invest in the US and buy US securities, indirectly bridging the gap between domestic savings and investment that form a current account deficit. In October, foreigners purchased a record $106.8 Billion in US securities, which include stocks, bonds, and treasuries. The lesson for currency traders is simple: until foreigners tire of US assets, don’t expect the USD to depreciate.

Read More: Foreign Capital Continues Rush into U.S. Stocks

There is currently a fierce debate in the US Congress over the future of American fiscal policy. This debate has taken on a new significance as some projections for this year’s budget deficit exceed $400 Billion. Thus far, the bond markets and forex markets have largely ignored the prospect of a larger-than-expected budget deficit, as treasury yields and the USD have remained stable. The consensus is twofold: first, the budget deficit will continue to play a backstage in currency markets to the trade deficit and other economic indicators. Second, as long as foreigners continue to purchase US Treasury Securities, the budget deficit will remain a moot issue. CNN reports:

If bond yields and the value of the dollar move this week, according to economists, it’s more likely to be because of signals from the Federal Reserve, or a Consumer Price Index report that shows inflation dramatically better or worse than current forecasts.

Read More: Markets and the deficit: No fear

In theory, the Chinese Yuan can fluctuate (read appreciate) by .3% per day. In reality, the Central Bank allows the currency to appreciate by less than .01% per day, which has limited the Yuan’s net appreciation against the USD to only .4% since the 2.1% revaluation in July. As a result, the G8 governments are clamoring with renewed vigor for China to further revalue. In fact, a rumor has been circulating that China will widen the Yuan’s daily trading bands to 1%, which would enable the currency to appreciate faster. Many analysts expect the Central Bank to announce such a move before the Chinese New Year on January 29th. Bloomberg News reports:

“Given the track record of the Chinese government preferring to announce key policy changes ahead of long holidays, it’s convenient for the market to anticipate the next key move on the renminbi could come in the later half of January,” said one analyst.

Read More: Currency Strategists: China to Let Yuan Gain Faster, UOB Says

Rydex Investments has finally introduced its much-anticipated currency ETF, which is the first of its kind. Exchange Traded Funds (ETF), while very similar to trusts and mutual funds, trade on an exchange like shares of stock. One ‘share’ of this particular ETF is equivalent to 100 Euros, currently valued around $120. The ETF will rise and fall in synch with the Euro currency, so investors can buy or sell shares much like they would go long or short actual Euros. The downside to the ETF is that investors will be charged an annual management fee of .4%, assessed monthly. After adjusting for interest, however, this fee will likely be closer to .1-2%. Marketwatch reports:

The Euro Currency Trust, with annual expenses of 0.4% of assets, allows investors to gain exposure to the euro currency, and could also be used as a hedging instrument. According to Rydex, the fund’s sponsor….the fund is eligible for short sale and margin purchases.

Read More: Euro ETF begins trading

This time of the year is traditionally among the least active for financial markets, as traders shut down their computers and spend a few weeks vacationing. Currency traders, however, may have to wait until next week to relax as a bevy of economic data is scheduled to be released in the next few days.

Most importantly, the Federal Reserve Bank will meet tomorrow, and likely raise short term interest rates to 4.25%. The rate hike is almost a given; accordingly, traders are more concerned with Greenspan’s commentary, which should provide a window into future rate hikes. Inflation data, which plays an important role in how monetary policy is conducted, will also be disseminated. Next to be released are US trade and current account data, which are expected to indicate near-record twin deficits. Currency traders will likely look past this, however, if capital flows data (to be released on Friday) indicate continued strength in US capital inflows. Dow Jones Newswires reports:

HSBC’s Lynch said the deficit numbers may not matter much in the markets, as long as the Treasury Department reports another strong month of capital inflows to the U.S. for October in its TICS report Thursday.

Read More: FOMC, Data May Hurt Fragile Dollar This Week

A leading adviser to China’s Central Bank recently confirmed what many analysts have suspected for months: a revaluation of the Yuan or RenMinBi will likely take place over the course of the next 1-2 years. The advisor publicly warned Chinese firms to make the necessary adjustments, in order to prevent the revaluation of the Yuan from severely harming their prospects for success. While not indicating the size of the revaluation, Yu Yongding hinted that it would be significant, in order to help China rein in its burgeoning trade surplus. Reuters News reports:

He said China’s big current account surplus, just like the large U.S. current account deficit, fundamentally reflected savings-investment imbalances in the two countries. “The rise in the renminbi’s exchange rate will definitely have an impact on China’s trade surplus.”

Read More: China firms told to prepare for stronger yuan

In a recent report, Britain’s Central Bank warned that the nation’s economy would likely grow at a pace of 1.75% in 2005, which would represent the worst year of growth in over a decade. This latest forecast is significantly from earlier forecasts of 3-3.5%, that the Central Bank had released earlier this year. According to experts, rising energy prices are responsible. Others pin the blame squarely on the slowing real estate market, which has spurred a sharp decline in the consumption component of GDP. Ironically, other G7 countries, including Germany and Japan, are finally showing signs of growth. Britain’s economy, however, seems headed in the opposite direction. The Wall Street Journal reports:

Calling 2005 “the toughest and most challenging” of his eight years as treasury chief, Gordon Brown blamed “a virtual doubling of global oil and commodity prices.”

Read More: British Growth, at 1.75%, Is Slowest Since 1992

Spurred by favorable interest rates, currency traders have bid up the value of the New Zealand Dollar to a 20-year high in trade weighed terms. This week, however, the NZD was a dealt a major blow, as Standard and Poor’s announced that New Zealand can no longer sustain its massive current account deficit, which is approaching 8% of GDP. In addition, the Central Bank of New Zealand announced the end of its policy of monetary tightening. If the US, Europe, and Canada continue to raise interest rates, the New Zealand interest rate differential will become less attractive. As the old saying goes, ‘what comes up must come down.’ The Financial Times reports:

The Australian dollar fell 0.7 per cent to A$2.3169 against sterling as soft GDP data strengthened a perception that Aussie rates have also peaked.

Read More: Headstrong kiwi flies too close to the sun

As the Yen continues its 3-year slide against the USD, many American trade groups are beginning to cry foul, claiming Japan has taken steps to artificially depress its currency. At $842 Billion, the Bank of Japan’s foreign exchange reserves are currently the largest in the world. Some American firms believe this is a consequence of calculated intervention in forex markets- buying massive amounts of USD denominated assets in order to hold down the Yen and make Japanese exports seem more attractive. For the record, Japan insists that the Yen’s current value is the product of market forces. Not persuaded, American trade groups have begun lobbying the US Treasury Department to shift its attention away from China, and begin pressuring Japan to allow the Yen to appreciate. Reuters News reports:

“There is no excuse for the G7 to get together and sit around talking about China when the currency imbalances and Japan’s policy of strongly encouraging that isn’t even discussed.”

Read More: Trade groups at odds over yen tactics

Last week, political pundits feared the worst when it was announced the Canadian Parliament had received a vote of no-confidence, and snap elections would be held next month. Currency traders, however, have reacted with indifference, sending the Canadian Dollar (Loonie) towards a 14-year high against the USD. Canada’s economy has boomed this year, on the back of record high commodity prices and strong exports. As a result, the Bank of Canada will likely to begin monetary tightening next week, by raising interest rates to 3.25%. If the Bank fulfills investor expectations by continuing to hike rates in the following months, the Loonie may continue to soar. The Edmonton Journal reports:

“The employment picture is solid, GDP growth is better than the bank expected and the U.S. economy is still rolling. Some are beginning to wonder if the bank won’t soon pick up the pace of rate hikes.”

Read More: Loonie hovers near 14-year high

Many economists and currency traders have suspected that the nations of OPEC (as well as other net oil exporters) were reinvesting the proceeds of rising oil sales into dollar-denominated assets. This theory was recently borne out by a release of official OPEC statistics, which indicate that OPEC nations have collectively shifted their forex holdings into USD. Specifically, 69% of OPEC forex reserves are now held in USD, which represents an 8% increase from last year. Many experts believe OPEC to be extremely sensitive to changes in interest rates. Accordingly, as the US Federal Reserve has repeatedly raised interest rates, OPEC nations have moved capital into the US in order to earn higher returns. The Financial Times reports:

If interest rate differentials are key to Opec behaviour, the start of the eurozone tightening cycle could end the dollar’s newfound popularity.

Read More: Dollar’s rise aided by Opec holdings

In a recent interview, the Finance Minister of Japan shrugged off claims that the Yen was undervalued and stated his conviction that the currency is consistent with Japan’s current economic situation. Japan’s economy has performed well in recent quarters, spurred by an increase in exports, which were in turn driven by a weak Yen. An influx in foreign capital has buoyed Japanese equities, and the Bank of Japan is currently mulling an interest rate hike. Meanwhile, the USD is moving towards a 3-year high against the Yen, and currency traders and economists, alike, are laboring to reconcile the increasingly positive outlook for Japan’s economy with the dismal performance of the Yen. The Japan Times reports:

Kaoru Yosano, economic and fiscal policy minister, separately said the dollar’s surge was not so much due to economic fundamentals as to the fact that long-term interest rates are significantly higher — and climbing — in the United States.

Read More: Weak yen OK, reflects state of economy, Tanigaki figures

In the last year, the Korean Won has soared against the USD, while the USD, in turn, has appreciated significantly against the Japanese Yen. In line with the laws of triangular arbitrage, the Korean Won has pummeled the Japanese Yen, appreciating over 30% in less than two years. As a result, Korean exporters are having extreme difficulty competing with their Japanese counterparts. While economic fundamentals still seem to support Won strength, a Japanese trade surplus should soon force the Yen back up. In addition, we could see South Korea’s Central Bank intervene in forex markets in order to hold down its currency. The Korean Herald reports:

Along with the wider liberalization of the foreign currency market, a shift in the fresh global capital inflow into the European Union and Japan away from the emerging markets is expected to put downward pressure on the won next year.

Read More: Decoupling of won from yen seen easing in 2006

For the first time in nearly five years, the European Central Bank (ECB) has hiked interest rates, from 2% to 2.25%. Three weeks ago, Jean Trichet, President of the ECB, signaled that the ECB would likely raise rates at its December meeting. For that reason, the markets did not react strongly to the news. Moreover, Trichet cautioned investors not to expect additional rate hikes. However, as inflation is still hovering well above the ECB’s target of 2%, thanks in part to high energy prices, it seems the ECB will likely follow up with another round of rate hikes next month, which should provide broad support for the Euro. The Economist reports:

But Mr. Trichet must tread carefully. Higher interest rates mean a stronger currency, which can hobble the exports crucial to economic recovery in the euro zone.

Read More: Trichet’s dilemma