As the year 2006 winds down, traders and investors are evaluating the performance of their portfolios, especially in the context of competing investments. One currency which stands out in forex markets is the South Korean Won, which has slowly and steadily inched its way upwards against nearly all of the world’s major currencies. In fact, the Won recently eclipsed a 9-year high against the Japanese Yen and has appreciated over 7% against the USD in the year-to-date. While the Korean Won has performed well over the last five years, this year the currency has attracted far less attention than in years past because Korea’s Central Bank abstained both from commenting on the currency’s rise and from threatening to intervene in forex markets to stem its appreciation. Perhaps, it realized such intervention is futile, since Korea’s economy is expected to grow 5% this year, perhaps positioning the currency for another strong performance in 2007.

Read More: Seoul faces dilemma over won’s climb

Over the last month, the USD has decline precipitously in value, to the extent that the currency is approaching a two-year low against the Euro, a 14-year low against the British Pound and an all-time low against the Chinese Yuan. Most economists had been predicting this decline for quite some time, and felt it was a matter of when it would happen- not if it would happen. With the release of US GDP data indicated that the US economy grew by a healthy clip last quarter, the decline in the Dollar was brought to a sudden halt. However, the news has already begun to dissipate in the markets and will likely soon be offset by dollar-negative news in the coming weeks. The Financial Times reports:

Analysts said that, while it might be something of a surprise that the dollar had failed to derive support from Mr Bernanke’s remarks, he might be in danger of “crying wolf” over US inflationary pressures.

Read More: Dollar relieved by economic growth

The Euro common currency seems keen on inviting more countries to join. The only problem is that the EU has established prerequisites for membership that even current members would find difficult to satisfy. These terms are framed around stability, especially with regard to price, currency, the economy, and the budget. Slovenia and Estonia have satisfied the economic and currency requirements but are experiencing difficulty in managing their respective budget deficits and controlling inflation. Meanwhile, other countries, such as Sweden and Belgium, which are eligible for Euro membership, are having trouble garnering public support for the common currency. In short, it could be five years or more before the Euro expands to include more members. The Economist reports:

Westerners are starting to feel uncertain too. The Euro zone may already have too many misfits (Italy, for example, or Greece).

Read More: An Uncommon Current

Over the last few months, the Chinese Yuan has picked up its pace of acceleration, to such an extent that it is now rising by an annualized rate of 7%. This has spurred two points of speculation: first, for how long will the Yuan continue to rise at this pace and second, will Hong Kong link its Dollar currency (HKD) to the Yuan? The answer to both questions is ‘probably not.’ The Yuan’s current rise is probably a conciliatory gesture to carping foreigners. With regard to the second question, Hong Kong is probably not likely to peg its currency to the Yuan because currency stability is important to its position as one of the world’s foremost financial hubs. In addition, Hong Kong is not subject to the level of international pressure that plagues its counterpart, so there is no real incentive for it to link its currency to the rising Yuan. The Economist reports:

As Hong Kong and mainland China become more economically and financially integrated, it seems inevitable that the Hong Kong Dollar will eventually be replaced by the Yuan. However, a merger will not make sense until the Yuan becomes fully convertible.

Read More: Yuan for all, all for yuan

The Pound is closing in on a two-year high against the USD en route to crossing the mythical barrier of 2 USD. Many traders and economists believe that it is only a matter of time before this threshold is breached- that it is a question of when and not if it will happen. This month, the Bank of England raised short-term interest rates to 5%, bridging the gap with US rates and eroding one of the last pillars that is propping up the USD. Once interest rates converge, many short term investors will likely shift funds out of US capital markets, and the USD will adjust to more closely reflect economic fundamentals.

Read More: Pound threatening $2 mark

According to a recent report, the Bank of Japan may raise interest rates at least once in the coming months. As Japan’s economy continues to surge ahead, the Central Bank is finding it difficult to justify its decade-long policy of easy money. Currency traders are watching this story closely, perhaps more closely than the monetary policy of any other country because it is Japan’s interest rate environment which is responsible for the record low valuation of the Yen. As long as interest rates remain at current levels, the carry trade (in which investors sell Yen and buy other currencies) will remain viable and continue to depress the Yen. AFX News reports:

It will take a definite signal that Japanese interest rates are set to rise further or that US interest rates are more likely to be cut than hiked next year, for the carry trade trend to dissipate, analysts said.

Read More: Yen recovers slightly…

While long-term currency investors and fundamental analysts are concerning themselves with numerous aspects of currency movements, there is only one thing currently on the mind of traders: volatility. In a word, volatility has virtually disappeared from currency markets over the last year, as most major currency pairs (namely the USD/Euro) are trading in tight ranges. Some would say that this is a product of a more perfect market- as more participants have driven down the margins of error that are synonymous with volatility. Along the same lines, many hedge funds have piled into currency markets, buying low-volatility options contracts. The third explanation is that due to a gradual convergence of global interest rates, perhaps traders are simply unsure as to the future direction of currencies, and are simply biding their time and waiting for developments. Regardless of the explanation, if history is any guide, we will probably witness a significant spike in the next few months.

Read More: How Long Will Low Volatilities in FX Markets Last?

Why is it that every political leader thinks his nation’s currency is undervalued? South Korea, China, and Japan all actively engage in some form of currency manipulation. American politicians argue that the USD needs to depreciate in order to prevent the burgeoning trade deficit. Most recently, the president of France jumped on the bandwagon of forex intervention, arguing that Europe needed to take steps to hold down the value of its currency. He went so far as to challenge European political leaders to fight the efforts of the ECB to tighten monetary policy, which he sees as partially responsible for the Euro’s recent strength. However, opinions were mixed as to whether the Euro will suffer. The Financial Times reports:

[One analyst] was surprised at the zeal of the currency market’s reaction, given that there was little Mr Villepin could do about the strength of the euro other than lobby the ECB.

Read More: French PM sparks fall in euro

Every month, almost like clockwork, when China announces its new total of foreign exchange reserves, a cloud of paranoia descends on currency markets, as traders weigh the likelihood of China diversifying its reserves. This month was different, however, as this paranoia seems to have been born out by Zhou XiaoChuan, chairman of China’s Central Bank. He stated explicitly that China would *continue* to diversify its reserves, but did not specify particular currencies or investments that would be targeted. However, the consensus is that any diversification by China, regardless of the scope, would surely benefit the Euro.

“Plainly, there’s a lot of sensitivity on this issue, and as an investor, one has to respect the market’s reaction.”

Read More: China’s reserve plans keep forex market on edge

The Pound has been idling near a multi-year high against the USD for several months now, but it can’t seem to break through the psychological resistance of $1.90. Against that backdrop, the Central Bank of the UK raised interest rates this week by 25 basis points, to 5%. This leaves UK rates potentially one rate hike away from parity with American rates, which seem more likely to be lowered than raised, given current circumstances. Narrowing interest rate differentials may remove the last barrier that has stood in the way of a broad-based USD decline. Perhaps, risk-averse investors will begin shifting some of their capital out of the US, and into UK and Europe, which is also in the midst of raising rates. The Financial Times reports:

The statement [of the UK Central Bank] did not give any clear signals as to the future path of UK interest rates and as such came as a disappointment to sterling bulls given the high probability that was attached to a follow-up rate rise in the first quarter of 2007.

Read More: BoE disappoints sterling bulls

Most of the reporting on foreign exchange reserves addresses the swelling stocks of Asian countries, namely China, Japan, and South Korea. But, as I have been reporting for several months now, the oil-rich countries of the Middle East are beginning to amass equally impressive stockpiles of reserves. In fact, it is estimated that by 2007, the Gulf Coast Countries will own a combined $500 Billion, with Saudia Arabia leading the pack with nearly $225 Billion. The irony, is that, while protectionists gripe about how soaring commodity prices are inflating the trade deficit, the oil exporters are simultaneously financing our deficit.

“These increases reflect a sharp improvement in current account positions in some countries, and higher foreign investments and other capital inflows in other countries,” IMF said.

Read More: UAE’s forex reserves to reach $29b

Chinese governmental officials have been somewhat quiet about the Chinese Yuan of late, perhaps not wanting to incite certain American politicians that are trying to lead the passage of a tariff on Chinese imports. In a recent press conference, officials broke the silence by hinting that the Yuan would witness an “accumulated slight revaluation”- meaningless rhetoric which translates roughly into ‘business as usual.’ In other words, barring some unforeseen economic or financial developments, forex traders can probably expect a 2-3% appreciation of the Yuan in 2007.

Read More: China Says Yuan to Continue `Accumulated Slight Revaluation’

At its monthly meeting held his week, the European Central Bank (ECB) left the benchmark Euro-zone lending rate unchanged at 3.25%. However, Jean-Claude Trichet, president of the ECB, announced that the ECB would exercise “strong vigilance” in monitoring economic conditions and weighing future rate hikes. While this kind of language could be confused as rather vague and generic, Trichet’s promise of “vigilance” has been used in the past to preface rate hikes. In addition, Trichet hinted that he would conform to the markets’ prediction that the ECB will raise rates in December. Meanwhile, the US economy is sputtering, and many economists expect the Fed to lower interest rates by a notch in the coming months, which could provide the impetus for the inevitable appreciation of the Euro. The Financial Times reports:

“We have a sneaking suspicion from the tone of the minutes that the ECB feels that it may well have at least a little more work to do in 2007 after December’s interest rate hike.”

Read More: ECB statement boosts the euro

The New Zealand Dollar (Kiwi) is still rallying against the world’s major currencies, due primarily to the country’s interest rate climate. Yesterday, I reported that that the carry trade is driving the Yen downwards, as investors short the Japanese currency in favor of higher yielding alternatives. On the other side of the carry trade stands the Kiwi, which is being driven higher by investors in search of yield. In addition, since New Zealand inflation is currently tracking near the top end of the Central Bank’s comfort zone, another rate hike may be in the cards, which would push New Zealand’s base rate to 7.5%. Bloomberg News reports:

There is a 44 percent likelihood of a quarter-point rise in New Zealand’s official cash rate on Dec. 7, when the central bank next reviews borrowing costs, according to an indicator calculated by Credit Suisse, based on trading in overnight interest-rate swaps.

Read More: New Zealand Dollar Rises to Seven-Month High on Rates Outlook