One technique for estimating the relative value of the Euro is to aggregate the value of all of the constituent EU currencies, using relative price movements as proxies for currencies. In Spain and Italy, for example, wages have skyrocketed over the past five years while productivity has lagged, which means these countries are relatively more expensive now. Germany, on the other hand, has been the economic leader of the EU, having benefited from declining real wages and surging productivity. When viewed as a sum of its parts rather than as a whole, Europe is plagued by many of the same economic problems that beset America, such as a negative balance of trade. A weighted average of European prices reveals a picture of what the Euro should be worth. Based on these three countries, it looks like the Euro is between fairly valued and overvalued. The Economist reports:

Spain now has the second-largest current-account deficit in the world in dollar terms. Germany’s resurgence has set a challenge for the euro zone’s southern members. Without the option of devaluation, their medium-term outlook looks less than rosy.

Read More: Beggar thy neighbor

While its economy expands, its currency sinks. This is the conundrum that currently defines Japan. At this point, it is evident that the weakness in the Japanese Yen can be almost solely attributed to low interest rates, which have spurred countless traders to borrow in yen and invest in higher-yielding currencies, as part of a carry-trade strategy. It seems Japan is either unsure that its economy can withstand a rate hike-which would elevate its currency-or simply unwilling to take such a chance when a cheap currency is spurring export growth. In any event, the G7 will officially take up the issue at a conference next month in response to rising foreign criticism that Japan is artificially holding the Yen down. The Financial Times reports:

“European” concerns over yen weakness might may actually reflect French and Italian concerns and with Angela Merkel, German chancellor, playing down worries over euro strength, the “G7 factor” may not last.

Read More: G7 speculation fuels volatile yen

The unthinkable has happened: China’s foreign exchange reserves have surpassed the historic level of $1 Trillion. Since the late 1990s, when China was continuously inundated with foreign direct investment, it has been forced to remove the foreign currency from circulation in order to mitigate the risk of inflation. Now, China has found itself in the unenviable position of managing the world’s largest cash reserves. As everyone knows by now, most of these reserves are held in USD-denominated assets, a phenomenon that has heretofore provided support for the USD while thoroughly muddling US bond markets. Imagine the effect on US capital markets if China decreased its USD holdings and invested the proceeds in its own economy. The Gulf News reports:

The composition of China’s reserves is secret, but economists believe about 70 per cent is in US Treasury bills, much of the rest in euros and a small amount in yen. Purchases of assets in other currencies are believed to be growing as the bank diversifies its holdings.

Read More: China in dilemma over forex reserves

Inspired by the success of the European Union, the Cooperation Council for the Arab States of the Gulf (GCC), which includes the nations of Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates, is aiming to establish a monetary union by 2010. The six-nation bloc plans to function in many ways like the EU, with a common currency and a common monetary policy. However, one nation, Oman, will not be participating in the union because of what it believes to be draconian conditions of membership. Specifically, Oman is not willing to adhere to the requirement that caps public debt at 60% of GDP, one of the prerequisites of membership. The Gulf News reports:

The GCC’s single currency plan can go ahead with the absence of one member state, like in the eurozone where only 13 countries out of the EU’s 27 adopted the euro.

Read More: Why Oman pulled out of the single currency

Currency exchange-traded funds (ETFs), which mirror the movements of the currencies that they profess to track, have witnessed a spike in popularity over the last year. Sitting at the crossroads of two of the most popular trends in capital markets-forex and ETF’s- these innovative investment vehicles are being praised for the access they bring to forex markets, by enabling retail investors to become involved in currency markets. In fact, currency ETF’s have attracted over $1 Billion in assets, spread across seven different funds. Some funds even pay dividends, based on interest rates specific to the currencies they track. The Motley Fool reports:

Giant institutional investors, such as banks and brokerages, have traditionally dominated the currency markets. Now individual investors can play in this market, too. Just be wary of the risks that come with it.

Read More: The ABCs of Currency ETFs

In a move that jived with investor expectations, the Bank of Japan voted last week to maintain interest rates at current levels, which leaves the benchmark lending rate of .25% the lowest in the industrialized world. While Japan has definitively emerged from its decade-long recession, policy makers apparently are not convinced that the economy is in strong enough shape to support a rate hike. Besides, the Central Bank is certainly enjoying downward pressure on the Japanese Yen in forex markets, since a cheap Yen makes for competitive exports, which are the cornerstone of Japan’s economy. The upshot is that the carry trade, in which investors borrow in Yen and invest in securities denominated in higher-yielding currencies, will remain a viable option for the foreseeable future. Reuters reports:

Even if the BOJ had lifted rates, many analysts believed a move would provide little relief to the yen because short-term Japanese interest rates remain so much lower than those of other currencies and the BOJ has pledged to lift rates only gradually.

Read More: Yen hits 13-month low, BOJ keeps rates on hold

The economic law of purchasing power parity (PPP) dictates that price levels and exchange rates should move in opposite directions. Stated another way, when a currency appreciates, its prices should decline proportionately so that the net effect on prices is zero. Methods for measuring PPP-let alone testing it- are imprecise. Recently, an Australian bank has capitalized on the success of The Economist’s Big Mac index and merged it with one of the most popular consumer electronics, the Apple iPOD. The result is the iPOD index, which uses the retail price of an iPOD in different countries as a basis for assessing relative currency valuation. The upshot for forex traders is that the USD inferred to be undervalued, since the US price of an iPOD is among the lowest in the world. The Financial Express reports:

Brazilians pay the most for an iPod, shelling out $327.71, well above second-placed India at $222.27. Canada was the cheapest place to buy a Nano at $144.20, while…the US was fourth cheapest at $149.

Read More: The iPod as currency markets index

That the USD has remained the world’s de facto reserve currency has surely prevented the currency from declining significantly at a time when economic fundamentals seem to warrant it. However, the USD is slowly losing its luster as many of the world’s central banks have formally announced plans to diversify their foreign exchange holdings by holding more assets denominated in assets. As if that weren’t enough, a tally of global bond issues revealed that for the second consecutive year, more bonds were denominated in Euros than in USD. In addition, US stock exchanges accounted for just 15% of global equity offerings, down from 60% in 2000. The implications for foreign exchange markets are ominous: the role of the USD in global capital markets is diminishing, which is bad news for USD bulls. The Financial Times reports:

As recently as 2002, outstanding euro-denominated issuance represented just 27 per cent of the global pie, compared with 51 per cent for the dollar.

Read More: Euro displaces dollar in bond markets

Since China revalued the Yuan in July 2005, the currency has appreciated by over 6% against the USD. Having since moved past the Hong Kong Dollar, the currency is showing no signs of slowing down. American politicians and trade representatives could not be happier. Their Chinese counterparts, on the other hand, are peeved. Many Chinese exporters have been forced to lower their prices in order to offset the rising yuan and maintain their competitiveness in overseas markets. Such exporters are complaining to anyone who will listen that a more expensive yuan is already eating into their profits. While China’s government prizes stability, it has not yet given any indication that it will halt the appreciation of the yuan in order to placate such malcontents. The Associated Press reports:

“When they started out on this process, they knew that some people would be hurt,” said Rothman. “If they can see the results are necessary to put the economy on a sounder footing long-term, then they can deal with the pain.”

Read More: China’s exporters suffering as currency rise

The British Pound received a boost today when the Central Bank of England raised interest rates to 5.25%, which represents parity with American interest rates. The move shocked investors and traders who expected the Bank to leave rates unchanged. Risk-averse investors are now fully incentivized to move funds to Britain since interest rate levels there are now among the most competitive in the industrialized world. Further, as the British economy still hasn’t peaked, it is possible that the Bank of England will raise rates further. Meanwhile, investors are already speculating as to when the Federal Reserve Bank will begin loosening its monetary policy, at which point it will officially be more attractive to invest in Britain. Either way, it seems the USD is in for a long and bumpy ride. The Financial Times reports:

The move sparked speculation that data next Tuesday could show December UK consumer price index inflation rising above November’s 2.7 per cent reading, since the committee would have had those figures in their possession.

Read More: Surprise rate rise boosts sterling

Since peaking in July, the Canadian Dollar has declined by over 6% against the USD, finishing the year down for the first time in five years. While movements in currency markets are often difficult to dissect, the reason for the fall of the loonie are not difficult to discern: falling commodity prices. Over the last few years, the Canadian Dollar has moved in near tandem with global commodity prices. Commodities now account for over half of Canadian exports, a figure which may grow further as Canada fine tunes its technique for squeezing valuable oil out of its now famous tar sands. Bloomberg News reports:

“The time to buy the Canadian dollar is nearing.” The currency will gain strength from a fast-recovering U.S. economy and the lack of a benchmark interest rate cut from the Bank of Canada in 2007, Citigroup predicted.

Read More: Canada’s Dollar Touches 11-Month Low as Commodity Prices Drop

What better way to follow up a summary and analysis of forex markets with a commentary on how they will perform in 2007! Specifically, how will the USD perform in the coming year? Economists and investors alike are basking in the decline of the Dollar in 2006. The current account deficit is projected to grow at an even slower rate this year as US exports become more competitive, and investors are earning spectacular returns upon repatriating gains achieved on foreign investments. Meanwhile, with the US economy slowing and subsequent predictions that the Federal Reserve will lower interest rates to facilitate a soft landing, it looks like more of the same for the USD in 2007. However, the Fed will have to balance a loosening of monetary policy with pricier imports that will result from the declining dollar. In addition, while the laws of economics dictate the USD should fall further, the laws of financial markets (if they can be called laws) may indicate that it has already fallen too much. BusinessWeek reports:

Currency analysts at JPMorgan Chase estimate that, based on long-term influences, including country-by-country differences in productivity, prices, interest rates, and risk, the greenback is now about 10% undervalued.

Read More: Why The Dollar’s Decline Isn’t A Downer

The books have been closed on 2006 for more than a week, which means it is time for the forex blogger to give his first-ever ‘state of the markets’ address. After a dull and static 2005, forex markets roared back into action in 2006, with several notable developments. On everyone’s radar screens, the world’s most important currency, the USD, declined by over 13% against the Euro and the British Pound. Analysts attributed the decline to narrowing interest rate differentials between the US and the rest of the developed world, as the US monetary cycle peaked while the rest of the world continues to raise rates.

In addition, several countries, notably China, Russia and several OPEC nations announced that they had already begun to diversify their foreign exchange holdings. This process is becoming auto-catalytic, which means that as the USD declines, it makes less financial sense for Central Banks to hold USD-denominated assets, which causes the USD to decline further, and so on. Meanwhile, the US economy is sputtering, and a majority of economists believe the Federal Reserves Bank will lower interest rates in 2007.

The Yen initially joined the ranks of the Pound and the Euro in their upward march, before retreating back to earlier levels, due to a couple reasons. First, low interest rates continue to make the carry trade a viable trading strategy, as investors borrow in Yen and invest in higher-yielding currencies, which effectively keeps the Yen grounded. Second, Japan’s Central Bank has repeatedly threatened to intervene in forex markets on behalf of the Yen, which has made investors wary about betting too much on its appreciation.

The Chinese Yuan accelerated upward, due primarily to American political pressure and the threat of trade sanctions. Meanwhile, the Thai Baht appreciated almost 20% against the USD, prompting Thailand’s Central Bank to step in and impose draconian capital controls intended to curb speculation. Emerging market currencies fared equally well on the heels of strong economic fundamentals and intelligent monetary policy that kept inflation on check. If these trends continue, expect 2007 to be a repeat of 2006.

Ignited by the threat of American trade sanctions and diplomatic pressure, the Chinese Yuan is now soaring against the USD. Last summer, it cleared through the psychological hurdle of 8 Yuan/USD and is now barreling towards 7.8. While this doesn’t strike most people as a significant milestone, the 7.8 barrier represents parity with the Hong Kong Dollar. Having traded below the HKD for nearly 13 years, the Yuan is now only weeks or even days away from overtaking its Hong Kong rival. In many ways, this event is symbolic of the broader economic Chinese economic explosion and its probable outstripping of the Hong Kong economy. Some analysts are predicting that when parity is breached, Hong Kong will immediately move to tie its currency to the Yuan, while others believe that the event will pass without much fanfare. The Financial Times reports:

Hong Kong-owned factories in China, long spoiled by renminbi-US dollar currency stability, are less than enthusiastic about the consequences of a stronger renminbi.

Read More: HK braces itself as renminbi nears parity

As the markets ease into 2007, investors and money managers are beginning to think about how they want to (re)allocate their portfolios. While hedge funds will likely remain a popular investment vehicle, investors would be wise to avoid certain types of funds, namely those that utilize a “global macro” strategy. Technically, such hedge funds examine global economic fundamentals and allocate capital accordingly. In reality, most of these funds make predictions about the global interest rate climate- specifically how interest rates will behave in relation to each other. Since currencies are often seen as proxies for interest rates, many global macro hedge funds are active participants in forex markets. And 2007 was an especially volatile year for forex markets, which translated into a rough year for global macro funds.

Read More: What’s hot and what’s not in hedge funds

The first trading day of 2007 saw the USD continue in the downward spiral that began in late 2006. Most economists agree that the US monetary cycle has already peaked, and disagree only when the Fed will lower rates. Meanwhile, speculation is increasing that the ECB will raise interest rates for a seventh time at its meeting later this month. As it stands now, the spread between comparable US and EU interest-bearing securities is under 100 basis points. An EU interest rate hike coupled with a decline in US rates could completely eliminate the slight advantage that the US currently enjoys in attracting foreign cash, which would certainly cause the USD to plummet. Bloomberg News reports:

The U.S. central bank will reduce its overnight lending rate between banks by the end of the year to 4.75 percent, according to sixteen of the 22 so-called primary dealers who trade directly with the Fed.

Read More: Dollar May Fall On Report Showing U.S. Manufacturing Weakening

Several weeks ago, the Central Bank of Thailand suddenly implemented capital controls designed to curb the inflow of foreign money that was causing the Thai Baht to appreciate. Speculation immediately began to mount that other Asian countries would follow suit, since many of the region’s other currencies also experienced significant appreciation in the latter half of 2006. Indonesia has become the first country to step forward and allay investor concerns by announcing that it intends neither to impose similar capital controls nor to intervene on behalf of its currency, the rupiah. Apparently, the country’s economic policy team believes that continued foreign investment will be critical to maintaining high GDP growth. The Wall Street Journal reports:

The rupiah has appreciated about 7% against the dollar this year, less than half the increase in the value of the baht. And Indonesia’s propensity to suffer from bouts of inflationary pressure will act as a natural brake on rapid currency appreciation.

Read More: Indonesia Won’t Intervene on Rupiah