As expected, Alan Greenspan raised short term interest rates to 4.5% today, before stepping down as Chairman of the US Federal Reserve Bank. Greenspan served as Chairman for 18 glorious years, steering the US economy through a period of prolonged growth and record-low inflation. His successor, Ben Bernanke, has already hinted that he will conduct monetary policy with the explicit goal of achieving economic growth at any cost. In addition, Bernanke has insisted that he will not raise interest rates in order to forestall potential bubbles in asset prices. As a result, it seems reasonable to expect interest rates to remain lower during Bernanke’s tenure, which could affect the USD. The Economist reports:

[High oil prices] posee a dilemma for the central banker: keep interest rates low, and fuel the kind of runaway inflation last seen in the rich world in the 1970s and early 1980s; or raise them, and risk pushing the economy into the doldrums.

Read More: Betting on Bernanke

Later this week, the two most important Central Banks in the world are scheduled to meet in order to decide whether to adjust their respective interest rates. The Federal Reserve Bank will be first to convene, on Tuesday, at which time it will likely raise short-term US interest rates from 4.25% to 4.5%. On Thursday, the European Central Bank (ECB) will officially announce it is holding interest rates constant at 2.25%. However, it is expected to lay the groundwork for a 25 basis point hike at its next meeting, which will take place in March. Also in the docket for this week is the official retirement of Alan Greenspan, who will step down after 18 years as Chairman of the Federal Reserve Bank. However, the change will not likely caused much of a stir in forex markets, as traders have had months to prepare. The Financial Times reports:

The Fed’s statement would leave Ben Bernanke, the incoming chairman, “wiggle room” to shape the policy debate but this could leave markets with a lingering question over how much higher rates could go.

Read More: Fed in focus for currency markets

At this week’s World Economic Forum, which is being held in Davos, Switzerland, China has predictably held center stage. Not all of the attention has been positive, however, as the US has used the Forum as an opportunity to lambaste China for its stubborn to further revalue its currency. Since last July, the Yuan has appreciated 2.5%, which is much less than what Western policymakers had hoped for. While senior US Treasury officials publicly rejected applying pressure to China via tariffs and other trade sanctions, they were adamant that China move forward on its plans to appreciate the Yuan, as it now has the financial infrastructure to support a more flexible currency regime. Reuters reports:

Economists at a session on the global economy in Davos, however, pointed out that the United States and China have a symbiotic relationship and that U.S. pressure for rapid revaluation might be misplaced.

Read More: Pace of China yuan reform takes center stage

In a national election held earlier this week, Canada’s Conservative movement, led by Stephen Harper, emerged as the winning party. Harper’s victory, according to many currency analysts, represents the best outcome, as Canada can now move past the corruption scandal which plagued the previous administration. The new administration may also implement certain structural reforms, so as to make Canada’s economy less dependent on natural resource exports. Meanwhile, Canada’s stock market continues to set records, and Canada’s Central Bank is moving to stem the interest rate differential between Canada and the rest of the developed world. CBC News reports:

“A Conservative majority is expected to generate a positive short-term reaction for the dollar, as some policy concerns will be partially alleviated.”

Read More: Markets, dollar set record on forecast of Tory win

While the US twin deficits have soared over the past few years, many currency traders have remained bullish on the USD. Their reasoning is that as long as foreigners remain willing to finance this deficit (by purchasing dollar-denominated assets), the USD should remain stable. However, while 2005 was a record year for capital inflows, there was an interesting trend that could spell trouble for the dollar if it continues. It seems a majority of capital inflows are now contributed by private, rather than public entities, leading many analysts to speculate Central Banks are slowing their purchases of USD. However, there is a glitch in the data, in that if a public entity buys USD through a private investment bank, then the transaction is recorded as private. The Business Online reports:

But regardless of how much of the cash is from governments and how much from private sources, one simple fact is clear: in the absence of a major shock, the dollar will continue to be supported by foreign capital.

Read More: Private vs Official Dollar Purchases

On paper, the case for a revaluation of the Chinese Yuan seems rock solid: China’s forex reserves have swollen to $800 Billion, its annual trade surplus exceeds $100 Billion, and its exports have soared. However, delve deeper into the figures, and a vastly different picture emerges. First, the country’s forex reserves are largely the result of ‘hot money,’ inflows of foreign capital hoping to instantaneously capitalize on a Yuan revaluation, rather than long term investment in capital projects. In addition, China’s trade surplus is increasingly a story of slowing imports, rather than growing exports. As investment in fixed capacity has declined, so has the demand for equipment and machinery, much of which is imported. In addition, while China’s trade surplus with the US exceeded $200 Billion in 2005, China runs a deficit with most other countries it trades with. The Economist reports:

So the balancing act, for the [Chinese] authorities, is to keep up the expectation of a revaluation through talk and an exchange rate that crawls up fractionally—by another percent or two here or there.

Read More: Strange happenings along the China coast

Over the past few months, there has been a back-and-forth between US trade lobbyists (mostly representing US automobile manufacturers) and Japan’s Central Bank. Specifically, US corporations have accused Japan’s Central Bank of repeated intervention in forex markets, designed to hold down the value of the Japanese Yen. The latest chapter in this saga unfolded yesterday, when the CEO of Daimler Chrysler suggested that the US match the efforts of Japan by intervening in forex markets and artificially depress the Dollar. Rick Wagoner, CEO of GM, recently expressed similar sentiments. Japan’s response to these allegations has been to proclaim its innocence. For almost two years, Japan has refrained from intervention, a fact that has since been verified by official data. The Associated Press reports:

“The Japanese Central Bank intervenes in currency markets to keep the yen cheap and to create an advantage for its industry. Why doesn’t our government do the same for us?” LaSorda [CEO of Chrysler] said.

Read More: Chrysler CEO suggests U.S. could intervene in currency markets

According to recent figures, the US current account deficit (the amount by which net investment exceeds US savings) is on pace to surpass $800 Billion. Moreover, the net value of US foreign assets (US ownership foreign assets minus foreign ownership of US assets) is a whopping -$2.5 Trillion. However, a new report released by two economists suggests the situation is not as dire as it appears. According to the report, despite the negative net US ownership of foreign assets, the US still receives positive net income on its foreign assets. Using back-end calculations, the economists figured the US net overseas investment is actually $700 Billion+. However, even if this number is accepted as truth, the economists warn that if current trends continue, net foreign assets will decline $3 Trillion over the next five years, during which point the USD may have to face the music. The Economist reports:

After making $36.2 billion in 2004, America made just $4 billion on its net foreign assets in the first three quarters of 2005. If it continues on its present trajectory, it will shell out about $190 billion in 2010.

Read More: America’s dark materials

Last year, over $300 Billion in currencies were traded via China’s foreign exchange market. 98% of this trade, however, involved China’s official interbank market, in which buyers and sellers are matched up in a centralized system. This will soon change, however, as China prepares to open the new market, in which currency trading will be facilitated by 13 banks, including five that are foreign. The Central Bank will continue to set the so-called parity price and control the Yuan exchange rate via calculated intervention. However, as part of the new system, private market-makers will have more discretion in setting prices, which could spur further Yuan appreciation. AFX News limited reports:

One analyst noted that current prices are not necessarily indicative of future trends on the two markets. “The key thing is now is they’ve got a market. People are going to push the envelope a little bit and…test the limits a little bit more,” he said.

Read More: China mulls upper tier of market makers in new OTC market

Earlier this week, a video tape of Osama Bin Laden was discovered, in which the Muslim leader warned of further terrorist attacks in the US. Originally, the news of the tape was thought to have contributed to the Dollar’s decline. In hindsight, however, it seems the tape merely provided an impetus for the USD to move in the direction that it had already been headed. This week witnessed a few releases of economic data, separately revealing that the housing market is continuing to slow while the labor market is tightening. Overall, the effect on the USD seems to be neutrals, as traders insisted that USD movements this week were related to technical, rather than fundamental factors. The Wall Street Journal reports:

“The bin Laden news helped move the market in the direction it was already going, but the market movements bring back thoughts that we might be in a range between $1.2050 and $1.2150,” said one analyst.

Read More: Dollar Edges Higher Against Rivals

For years, New Zealand has been home to the highest interest rates in the first world. Accordingly, it has had very little difficulty financing massive budget deficits, as foreigners have been all too eager to earn high returns lending it money. However, the government has become increasingly concerned that it may have issued too much debt, warning the Japanese government that further issuance could threaten the stability of the New Zealand Dollar. Basically, the bonds have significantly increased the amount of New Zealand currency in circulation, which could lead to inflation. If the law of purchasing power parity holds, the New Zealand Dollar will move in the opposite direction as prices. AFX News Limited reports:

The Kiwi is ‘near to the top of most people’s lists of things to sell this year’, with interest rates expected to fall.

Read More: NZealand dollar slumps as govt holds talks with Japan on uridashi bonds

In the last week, the Japanese stock market witnessed a massive ‘correction,’ as the Nikkei Index fell by almost 10%. Accordingly, many reckon the markets’ year-long strength may be coming to an end, and are warning against the possibility of investors removing their capital and transferring it to other countries, namely the US. In the last month, US capital inflows far exceeded the current account deficit, which can be attributed to continued faith in US capital markets. Analysts have cautioned, however, that the USD could depreciate if foreigners suddenly lose their appetite for investing in the US. The Financial Times reports:

[One economist] warned he “feared the worst for the dollar” if yield differentials were to become more attractive elsewhere. Another bearish factor for the dollar would be if equity weakness lowered expectations for further tightening, he added.

Read More: Yen shrugs off plummeting Nikkei

Since 2001, South Africa has been an emerging markets superstar, having seen its currency, the Rand, more than double against the USD. On paper, the Rand’s appreciation seems to be supported by fundamentals. South Africa has narrowed its budget deficit, core inflation is low, and interest rate levels have stabilized around 7%. However, currency traders continue to view the Rand as risky. In most developing countries, high bond premiums are usually attributed to default risk, the likelihood that the government will default on the debt. In South Africa, by contrast, a recent study found 90% of bond premiums could be explained by currency risk. It seems investors are not worried about the government defaulting, but rather they are concerned about the possibility of Rand depreciation. The Economist reports:

Unusually, the Rand is a popular hedging tool for foreigners. The average daily trade in Rand has ballooned since 1998 to nearly $14 billion, most of it by non-residents.

Read More: An Eye on the Rand

The mandate of Central Banks is simple: to guard against inflation. Accordingly, Central Banks attempt to maintain price stability through monetary policy (adjusting interest rates). However, many economists feel central banks should also respond to changes in asset prices. While not a direct component of inflation, asset prices often drive consumer spending, as individuals feel psychologically wealthier as the value of their portfolios and homes appreciate in value, and consumer proportionately more. The implications of asset price-targeting for forex markets are clear: if the Federal Reserve, for example, raises interest rates in response to an asset bubble, than the USD should experience a short-term appreciation before ultimately sliding in the opposite direction. The Business Online reports:

If the Fed started to put up rates with share prices, this would boost spreads in favour of the dollar. But it would also trigger capital losses in the bonds market and dampen economic growth, hence profits and share prices. The question is which of these effects would have the greatest impact on the dollar.

Read More: Setting rates could become an asset

As 2006 sets in, economist and analysts are beginning to release their forecasts for the USD in 2006. Their models vary widely, as some place more emphasis on economic indicators (namely the current account balance), while others merely reflect assumptions for interest rate differentials. According to the latter type, the USD is actually undervalued, by as much as 10%. Such models posit that the current discrepancy is merely a premium of uncertainty surrounding current monetary and economic conditions. Models based on the current account balance, in contrast, suggest the USD is heavily overvalued. The economists behind these models believe that 2006 could be a rough year for the USD, as the willingness of foreigners to finance the rising US twin deficit begins to wane. The Economist reports:

According to economic theory, it is the widening of interest-rate differentials that temporarily strengthens the exchange rate. Over time, an international difference in interest rates is offset by a drop in the currency with the higher interest rate.

Read More: The greenback’s sinking feeling

At its most recent meeting, the European Central Bank (ECB) elected to maintain interest rates at current levels. While the lack of tightening shouldn’t come as a surprise to anyone, Euro bulls are surely reeling, as an increase in interest rates would have narrowed the differential between the EU and the rest of the world, and likely buoyed the Euro in the process. However, Jean Trichet, President of the ECB hinted towards the possibility of a rate hike at the bank’s next meeting, in March. He cited an economic turnaround in some of the EU’s largest economies, due to a surge in exports. The Wall Street Journal reports:

Recent data from the 12-nation euro-currency zone had confirmed the forecasts made by the ECB and national central banks, implying that a case for gradually tightening monetary policy remains. Many economists expect the ECB to raise rates gradually to 3% by the end of 2006.

Read More: ECB Suggests Rate Increase Is Still Possible

In just the first two weeks of 2006, the Yen has already managed to appreciate 3.5% against the USD, costing some of the most prominent macro hedge funds hundreds of millions of dollars in losses. Hedge funds, with their vast pools of investment capital and proportionately large research teams, are usually ahead of the curve in financial markets. That so many of them failed to foresee the USD’s sudden slide has come as a great surprise to many analysts. Many hedge funds have interpreted the recent fall in the value of the USD as a harbinger of further depreciation. Accordingly, they have quickly and significantly cut their long positions in the USD, a fact that is born out by official statistics. Reuters reports:

Long dollar positions measured against the yen, euro, sterling, Swiss franc, Canadian dollar and Australian dollar were cut to 1,241 futures contracts in the week to January 3 from 24,274 contracts the week before, according to the CFTC.

Read More: Hedge funds caught out by dollar slide versus yen

Last week, officials from China’s Central Bank announced that they would “actively explore more effective ways to utilize [forex] reserve assets.” Many analysts interpreted this remark as an explicit signal that China would begin ‘diversifying’ its foreign exchange reserves, by holding fewer USD and more of other currencies. However, as the speculation began to reach fever pitch, the same group of officials announced that their previous statement had been misinterpreted. In fact, existing USD reserves play a vital role in helping China maintain its peg to the USD. Accordingly, any ‘diversification’ will only affect new reserves. The Daily Times reports:

“The general trend is that every country wants to diversify its reserves. No one is willing to put all of their eggs in one basket and it is impossible for China to put all its forex reserves, which exceed $800 billion, in one currency.”

Read More: China unlikely to sell dollar reserves

Despite a current account deficit that smashed through the $800 Billion mark last year and continues to expand, many currency traders remain bullish on the USD. Their reasoning is that as long as foreigners remain willing to buy US assets and indirectly finance the US deficit, than the USD will continue to appreciate. However, notes Harvard economist Martin Feldtsein, this line of reasoning is becoming increasingly tenuous. Contrary to data released by the Treasury department, much of the foreign capital the flowed into the US last year was contributed by public/governmental institutions, rather than private investors, as had previously been put forward. Feldstein further argues that as interest rate differentials between the US and other nations narrow over the next year or so, many investors will begin pulling their money out of the US. At which point, the USD should theoretically fall 30% in trade-weighted terms, in order to condense the US trade deficit to a manageable amount.

The New York Board of Trade (NYBOT) recently became the first exchange to offer a futures contract for trade-weighted Euros. Previously, institutions and companies wishing to hedge their exposure to the Euro currency were forced to buy contracts on a specific currency pair (typically the USD-Euro pair). With the advent of this new futures contract, they will now be able to protect themselves against changes in the Euro, relative to a basket of currencies. In addition, individuals who wish to bet solely on or against the Euro, can now do so, without worrying about how the USD will perform relative to the Euro. The Financial Times reports:

The NYBOT contract is based on a weighted average of the euro against five other currencies; the US dollar, sterling, yen, Swiss franc and Swedish krona. This is less comprehensive than the 23 currencies the European Central Bank uses to calculate the euro’s nominal effective exchange rate.

Read More: Nybot set to offer euro contracts

While currency traders often discuss interest rate differentials in the context of the USD and Euro, the concept is more closely tied to movements of the Yen. Japanese interest rates remain at depressed levels; the annual yield on Japan’s 10 Year note is currently 1.3%, a full 3 percentage points below the US equivalent. Accordingly, Japanese investors continue to pour money into foreign assets, where yields are significantly higher. This may prove increasingly problematic for the Yen, as Japanese corporations and individuals have suddenly found themselves with more cash to invest, due to the recovery of Japan’s economy. That they are investing profits and savings, respectively, into foreign securities rather than into their home economy, is not a good sign for the Yen. Bloomberg News reports:

Japanese investors bought 16.6 trillion yen ($145 billion overseas assets last year, according to figures based on reports released by the Ministry of Finance.

Read More: Yen Drops on Speculation Japanese Investors Seeking Higher Returns Abroad

While the beginning of a new year is technically irrelevant to financial markets, the event wields enormous psychological power, in that investment strategists relish the opportunity to review the markets’ performance over the previous year and make predictions for the year ahead. This is especially true in forex markets, as currency strategists often make significant bets in the beginning of a new year. In January 2005, for example, traders believed the dollar would continue its multi-year slide against most major currencies. Accordingly, many such traders, notably Warren Buffet, made billion-dollar bets against the USD. One year later, the USD stands much higher against the Yen and Euro. Is there a lesson to be learned from this?

While the answer is unequivocally ‘yes,’ that forex markets are intrinsically unpredictable, many currency traders are once again making big bets. This time, however, most are betting that the USD will continue to appreciate. Unfortunately, Dollar bullishness appears nothing short of foolish at this point. The twin deficits are projected to continue soaring, and the US economy will likely slow in 2006. Moreover, the end to the Fed’s interest rate hikes is approaching fast, which will reduce the relative attractiveness of investing in public and private US securities. On paper, therefore, it looks like a repeat of 2005 for many wealthy investors, who are in position to get burned.

In the last few weeks, the Euro finally broke through a level of resistance, against the USD, appreciating several cents. Whether the Euro continues to trade outside of its range will depend largely on whether the ECB raises interest rates in the next few months. Accordingly, Euro bulls are anxiously awaiting the release of German investor confidence data. While such data seems trivial and would not normally merit serious consideration, currency traders believe data supporting solid growth in Europe’s largest economy could be enough to tip the ECB in favor of hiking rates in the near-term, which would in turn, support the Euro. Bloomberg News reports:

“Amid the prevailing dollar-bearish sentiment, strong data in Germany could surely push up the euro again. Should the index rise more than expected, it will certainly raise expectations for ECB rate hikes,” said one currency strategist.

Read More: Euro May Advance on Speculation German Investor Confidence Rose

In a surprising revelation, representatives from the Bank of China publicly hinted that China may soon begin ‘diversifying’ its massive foreign exchange holdings. While currency strategists always pay heed when countries make such announcements, the case of China is especially noteworthy for the simple fact that China’s reserves total nearly $800 Billion, 70% of which are held in USD-denominated assets. Economists agree that it is unlikely will diversify much of its existing reserves, which play a central role in maintaining the de facto Yuan-Dollar peg. Instead, China will likely begin investing a portion of the $15 Billion in new reserves it accumulates each month into European or Japanese assets. Either way, in the context of China, any move towards diversification would make a big splash in forex markets.

Read More: China signals reserves switch away from dollar

Earlier this week, the Bank of China issued permits to several foreign and domestic banks, which enable them to serve as market-makers for the Chinese Yuan. Yesterday, the Bank of China further explained the new system, stating that the Yuan’s daily opening price would be calculated based on an average of spot rates offered by 13 market-makers. While the Bank of China, through its forex reserves, could still technically manipulate the value of the Yuan, this latest development makes it more likely that the Yuan will be allowed to appreciate in 2006. In fact, futures markets have priced in a 4.3% appreciation for the entire year. Some currency strategists are even more bullish, as the Financial Times reports:

We remain convinced further renminbi strength is highly likely,” said Thomas Stolper, global markets economist at Goldman Sachs, who sees the renminbi rising 9 per cent to Rmb7.34 to the dollar by the end of 2006.

Read More: Renminbi expected to rise after new trading rules

In the last three years, the Canadian Dollar has appreciated over 35% against the USD! Most of those gains, however, took place in 2003 and 2004, as the Loonie only appreciated 3.5% in 2005. Accordingly, many currency strategists believe 2006 will be a flat year for the Canadian currency, due to declining commodity prices and a stagnant economy. In fact, recent economic data suggest that these two variables are closely related, as Canada relies heavily on commodity exports to drive its economy. Nonetheless, 2006 should witness hikes in Canadian interest rates, which could draw inflows of foreign capital. In short, there are competing forces tugging at the Loonie, which could conceivably be pulled in either direction. CBC Business News reports:

The central bank has raised its trend-setting overnight interest rate three times in recent months, to 3.25 per cent, to keep inflation from taking off. Analysts have said the bank could push the key rate as high as four per cent in 2006.

Read More: Canadian dollar falls more than full U.S. cent as commodity prices slip

In a move that is sure to turn a few heads, China will soon allow over-the-counter trading in its Yuan currency. In addition, several domestic banks and a few foreign banks have been awarded market-maker status in the new system, which legally enables them to buy and sell Yuan to market participants. Previously, only large financial institutions were permitted to trade the Yuan, via the interbank market. While the Yuan will still be prevented from fluctuating by more than .3% per day, critics of China’s fixed currency regime have hailed the move as a step towards a floating currency. The Financial Express reports:

Effective from Jan. 4, the central bank would authorise the China Foreign Exchange Trade System to announce the central parity of the yuan exchange rate against the dollar, the euro, the Japanese yen and HK dollar at 0115 GMT each day.

Read More: China to kickstart yuan OTC trade, market-maker system

On the first day of trading in 2006, the USD recorded its largest daily loss since September 11, 2001, falling nearly 2% against the Euro. On the first day of trading in 2005, in contrast, the USD rose significantly, as part of a broader trend of appreciation against the world’s major currencies. That the dollar fell in its first 2006 trading session has led many forex analysts to speculate that the year will not be kind to the USD. Specifically, the dollar fell due to a combination of weak economic data and the ‘minutes’ from the last Fed meeting, which suggest the Fed may slow its planned monetary tightening. Many analysts are pointing to the disappointing manufacturing data and the recent flattening of the Treasury yield curve as evidence that the US economy is faltering and will soon plunge into recession, leading the Fed to stop raising interest rates. Daily FX reports:

The FOMC minutes released today reflected the varying views on the degree of future rate hikes. Additional increases “probably would not be large” and “members thought that the policy outlook was becoming considerably less certain.”

Read More: Dollar Sees Largest One Day Slide in 4 Years

For the last few months, several American trade lobbyists have publicly accused Japan of calculated intervention in forex markets aimed at holding down the value of the Japanese Yen. Japan’s repeated declaration that these claims were groundless and untrue was born out recently by Japan’s Ministry of Finance. Data indicates that from January 2003 until April 2004, Japan spent almost $350 Billion USD to slow the appreciation of the Yen by purchasing USD on the open market. Since April 2004, however, Japan has refrained from any intervention, which means its current value (to the chagrin of American trade groups) reflects market fundamentals. AFX News Limited reports:

The absence of dollar-buying and yen-selling via the Bank of Japan was attributed to the orderly reversal of the dollar’s weakness, reflecting the stronger fundamentals of the US economy compared with that of Japan.

Read More: Japan says it kept out of currency markets in 2005