Today, the Federal Reserve Bank lowered interest rates for the second time in as many weeks, bringing its benchmark federal funds rate down to 3.00%.  The Fed has now lowered rates by 2.25% since August. The move came as a relief to investors, who now see that the Fed is serious about preventing the economy from slipping into a full-scale recession. However, it remains to be seen whether the rate cuts will provide the necessary boost to the economy or instead prove too little too late. As far as the Dollar is concerned, the rate cuts carry two (conflicting) implications.  On the one hand, the economy and stock market could rally, which would likely be matched by a Dollar rally.  On the other hand, the interest rate differential between the US and EU is now a 1% and risk-averse investors hungry for yield will be hard-pressed to justify shifting capital to the US. The New York Times reports:

Many economists are far from convinced that even a combination of tax rebates and cheaper money would prevent a recession. And in a sign that bond investors are fretting that the moves could lead to higher inflation, yields on 10-year and 30-year Treasury securities edged up slightly on Wednesday.

Read More: Fed Cuts Key Rate as Stimulus Plan Advances

For at least the duration of the current administration, the official US stance towards its currency has been a "strong dollar" policy.  In hindsight, it appears that this policy was entirely baseless, since its was directly undermined by the simultaneous easy monetary policy, and thus it stands to reason that US policymakers did not actually believe that a strong Dollar policy was necessary to pursue.  In a recent op-ed piece published in the Wall Street Journal, one analyst outlines the case for a strong dollar, and by extension, why the depreciating Dollar is bad for the US economy. 

First, since oil contracts are settled in Dollars, a weak Dollar has directly contributed to high oil prices, which has several negative economic and geopolitical consequences. Second, a cheap Dollar is eroding the purchasing power of US consumers directly by making imports more expensive and indirectly through inflation. Third, the weak Dollar shifts the balance of economic power in favor of US competitors, which don’t need to grow as fast to keep pace with the US, in Dollar terms.  Finally, the recent weakness threatens the long term reserve status of the Dollar, which has important implications for economic growth and jobs creation.

On the other hand, argues the analyst, the conventional wisdom that a declining Dollar is necessary to correct the current account and trade deficit is bunk, since much of the trade deficit is accounted for by intra-company trade and since the current account deficit is generally overstated and not connected to currency valuations. In short, he argues, it is in the best interest of the US to align its rhetoric with its economic and monetary policies such that the long term luster of the Dollar is restored.

Read More: The Dollar and the Market Mess

When America’s dot-com bubble collapsed in 2001, the Federal Reserve Bank moved quickly to quell the panic by slashing interest rates.  The European Central Bank (ECB), on the other hand, was adamant that it would not have to follow suit since the European and American economies were no longer so intertwined.  Several months later, it became increasingly clear that the ECB was wrong, and it was ultimately forced to lower rates.  Now, some analysts fear that history is repeating itself, as America’s housing crisis threatens to run a similar course as the collapse of the stock market bubble. The Fed has lowered interest rates twice in the last few months, while the ECB has yet to act, insisting that its primary concern is inflation. For now, the interest rate differential is supporting the Euro, but if the ECB falls behind the curve, a stagnating EU economy could bring down the common currency.  The New York Times reports:

But when it comes to the economy, Europe remains optimistic it can decouple itself and withstand collateral damage from a possible recession in the United States.

Read More: Why the European Bank Is Sitting Back

Last week, the Bank of Canada cut interest rates by 25 basis points, bringing its benchmark lending rate down to 4%.  Fortunately for the Canadian Dollar, the rate cut paled in comparison to the 75 basis point move effected by America’s Federal Reserve Bank. While the Bank of Canada offered a hackneyed rationale of "keeping aggregate supply and demand in balance"  for the change in monetary policy, there is still some surrounding haze since Canadian inflation is rising and economic growth is strong. The currency had slipped below parity against its American counterpart, but is now slowly crawling its way back. If commodity prices remain high, the currency will likely push back across that psychologically important barrier of 1:1 with the USD.

Read More: Canadian dollar firms as BoC cuts rates

The South African Rand is not the subject of much analysis in the forex community, which typically confines itself to the majors and the BRIC currencies – Brazil, Russia, India, and China. But recently, the Rand found itself on the radar screen  of at least one analyst, who pondered the implications of a growing trend towards risk aversion. It appears that the Rand has resumed a clearly identifiable downward path against the Dollar, a course which had been temporarily interrupted in the early years of the decade.  Now, inflation is picking up  again and investors globally are becoming more hostile towards risk, two factors which bode ill for the Rand.  On the other hand, South Africa is rich in natural resources; judging from the performance of the Canadian Loonie and the Australian Dollar, commodity economies are still in vogue. The Times reports:

The curve ball for precious metals would be a sustained stronger dollar, unlikely while the US economy is in its current predicament and the Fed is cutting rates.

Read More: A warning to beware of banking on the rand

So-called ‘Sovereign Wealth Funds’ are the talk of the town, stealing headlines as part of a multi-billion dollar buying spree.  Anecdotally, stories of these funds and other institutional foreign investors have made a big splash, epitomized by a few high-profile investments in struggling American investment banks.  It no longer appears these stories were isolated, as suggested by some pretty compelling economic data.  In 2007, total foreign direct investment into the United States totaled $400 Billion, which represents a 90% increase over 2006.  In addition, the first few weeks of 2008 saw a frenzy of activity, which suggest this trend will continue.  Investment in the US is being driven primarily by a weak Dollar and attractive stock market valuations.  If the bad news on the US economy continues to pour in, analysts warn that foreigners could play an even larger role in mitigating against recession. The New York Times reports:

The weak dollar has made American companies and properties cheaper in global terms. Even as Americans confront the prospect of a recession, economic growth remains strong worldwide, endowing oil producers like Saudi Arabia and Russia and export powers like China and Germany with abundant cash.

Read More: Overseas Investors Buy Aggressively in U.S.

Last week, the New York Times published an article with the byline "Is the Federal Reserve’s chairman, Ben Bernanke too nice for the job?" Apparently, talk had been building on Wall Street that Bernanke was not tough enough to deal with the growing problems faced by the world’s largest economy.  Bernanke responded publicly in a speech in which he promised that the Fed would act quickly and decisively to confront such problems.  Then on Tuesday, the critics were silenced peremptorily by a Fed rate cut of 75 basis points, the largest single cut in two decades. Moreover, Bernanke intimated that additional rate cuts could come as soon as next week. 

It’s unclear how this activity will affect the Dollar.  On the one hand, it implies beyond a reasonable doubt that the US economy is indeed headed for recession.  Bond yields are declining and the stock market has lost 15% of its value since October.  On the other hand, the Fed has demonstrated that it is willing and able to take the necessary steps to avoid a hard landing at any cost. At the same time, investors around the world fear that a US recession will have an adverse impact on the global economy.  And where do investors park their money during periods of global economic uncertainty? Answer: USA. Sure enough, the Dollar has already begun to rally after taking a big hit immediately following the rate cuts.

Read More: Fed Rate Cut Halts Market Free Fall

As Asian capital markets crash in unison, the Japanese Yen is rising at its fastest pace in years.  Taken out of context, that sounds like a contradiction, since a positive correlation typically obtains between the strength of a nation’s economy, capital markets, and currency.  However, the Yen is unique, as most forex traders are doubtlessly aware.  The Yen rises and falls with the whims of the carry trade, which in turn is tied closely to volatility.  And in case you haven’t noticed, global capital markets are seesawing to such an extent that by some measures, volatility levels have reached a nine-year high.  One analyst has drawn a parallel between the current credit crisis and the 1998 Asian economic crisis, which also produced a Yen rally.

Read More: History Points to a Yen Rally

When Henry Paulson was appointed Secretary of the US Treasury last year, he made China and its purportedly undervalued currency a cornerstone of his economic plan. Lo and behold, several months ago, the Yuan suddenly accelerated in its upward path against the Dollar, rising at an annualized rate of 14%. Currency futures are now pricing in an 8% rise in 2008, while several economists are forecasting a 10% increase.  Ironically, there are still American policymakers who think the Yuan is appreciating too slowly, as well as Chinese policymakers who reckon it is increasing too rapidly.  Accordingly, the current pace probably represents a fair compromise.  Besides, inflation is threatening the US, so a slow appreciation would enable the economy to adjust to higher prices in the long term.  While China also faces rising inflation, it doesn’t want to send investors the message that the movement of its currency is uni-dimensional, which would encourage further inflows of speculative capital.  The Economist reports:

But Chinese policymakers have stressed the need for gradual adjustment.
To show that the currency is not just a one-way bet, the PBOC may try to nudge the yuan a bit lower in coming days.

Read More: Revaluation by stealth

In a recent editorial published in the Wall Street Journal, the Chief Economist for Bear Stearns (an American investment bank) advocated intervention by America’s Federal Reserve Bank on behalf of the Dollar.  He reasons that the best way both to fight and inflation and alleviate the possibility of recession is to strengthen the USD.  Current measures, which include lowering the discount rate and manipulating the money supply, are actually worsening inflation.  As a result, institutional investors are moving their capital en masse outside the US in order to prevent the declining dollar from corroding their investment returns. While paying lip service to the prevailing wisdom that Central Banks are essentially impotent when it comes to managing currencies, he insists that strong rhetoric by the Fed could conceivably convince investors that it stood behind the "Strong Dollar Policy" it promotes.  The Wall Street Journal reports:

By saying they want a stronger dollar, the Fed…could make it happen. Government policy makers have almost absolute control over perceptions of the future scarcity of dollars. This controls the demand for dollars almost as much as it does the supply, setting its value as much or more than rates do.

Read More: Markets and the Dollar

On January 24 last year, the Forex Blog reported with great fanfare that China’s forex reserves had breached the epic milestone of $1 Trillion. [In hindsight, it turns out that the psychologically important barrier was broken several months earlier, but that is beside the point].  Less than one year later, China’s forex reserves reached another important threshold, soaring past $1.5 Trillion. It appears that new reserves are being accumulated at  an exponential rate, having increased $460 Billion last year and over $30 Billion in the month  of December alone. By no coincidence, China’s 2007 trade surplus of $262 Billion shattered the previous record and is expanding at a comparably supersonic pace.

Most analysts reckon that the country is locked in a vicious cycle: when its trade surplus grows, its forex reserves grow proportionately. Moreover, the lopsided trade imbalance th\at China maintains with most of the world ensures that the demand for Chinese Yuan exceeds the supply. In the short run, a more expensive currency equates to higher prices paid for its exports which only increases the trade surplus and forex reserves further, and exerts still more pressure on the currency to appreciate.  Meanwhile, as the Yuan rises, the value of China’s forex reserves, which are denominated predominantly in USD, falls.  What a conundrum indeed! Xinhua News reports:

The value of Chinese RMB against the US dollars has appreciated by over six percent in 2007. The central parity rate of the RMB was 7.2672 to the US dollar on Friday.

Read More: Forex reserve tops $1.53 trillion

Since July, the Japanese Yen has notched a stellar performance in climbing 15% against the Dollar, without garnering much attention.  Within the last week, however, analysts have begun to take notice, as the carry trade temporarily collapsed and the Yen appreciated by another 3%. ‘But Japan’s Central Bank is no hurry to raise interest rates,’ you are probably wondering. ‘What on earth is all the fuss about?’ Volatility, the sworn enemy of carry traders has exploded.  Global capital markets, including the US stock market, are in a state of turmoil. The financial services industry, the perennial bulwark of the US economy, is set to record its worst year in recent memory.  Leading the way, so-to-speak, is Citigroup, which recently announced that it will write-down an additional $10 Billion in worthless subprime paper and will also receive a proportionately large infusion of capital.  Cue exit music for carry traders. Bloomberg News reports:

"The global and risk environment is dominating yen pricing,” said Chris Turner, head of currency research at ING Financial Markets in London. "There’s risk aversion in the background.”

Read More: Yen Rises as Traders Pare Carry Trades on Credit-Market Losses

As we wrote last week, the direction of the Dollar may be influenced more by external economic events rather than by internal activity.  Accordingly, it would behoove forex traders to direct their attention away from the Fed and towards the Bank of England and the European Central Bank, both of which face important monetary policy decisions later in the month. With regard to the Bank of England, futures markets have priced in a 2/3 chance that rates will be cut by 25 basis points. In the case of the ECB, the markets are expecting rates to be maintained at current levels. However, analysts will be scrutinizing the Banks’ respective press releases and monitoring other developments in this area due to the implications for the US-EU-Britain interest rate differential.  Reuters reports:

Some analysts think that hawkish comments from Trichet will be brushed aside with weaker economic data leading to the prospect of falling euro zone rates later in the year.

Read More: Pound down, others flat before ECB, BoE decisions

2008 is still in its infancy, which means the self-proclaimed forex experts can be excused for offering their projections on what the year has in store for the Dollar.  If currencies were traded in a vaccum, the Dollar would probably trend upward, since many technical factors suggest it is oversold.  From a fundamental standpoint, however, it is probably overvalued, per the laws of interest rate parity and purchasing power parity.  Relative to other countries, though, it may be undervalued.  From this standpoint, argue some analysts, the biggest impetus for a Dollar upswing will come not from good news emanating from the US, but rather from bad news emanating from the rest of the world.  For example, the British economy, balance of trade, and monetary policy outlook is even more bleak than the US.  The CEO of Airbus, one of the EU’s most important companies, has threatened to shift production away from the EU if the Euro remains expensive.  Finally, the Central Bank of China is allowing the Yuan to appreciate at a faster pace against the Dollar.  As far as Dollar bulls are concerned, it might be best if the US government simply sits tight. The BBC reports:

"A lot of bad news is already priced into the dollar. It’s elsewhere that the shocks could come from, perhaps from the European Central Bank, or the Bank of England."

Read More: 2008 – the return of the dollar?

Recently, most of the news regarding the Dollar has, frankly, not been positive.  The housing crisis is beginning to take its toll on the broader economy.  The Fed is planning to lower interest rates at its next meeting, which will eliminate the positive differential with Euro-zone rates.  High commodity prices are driving inflation and eroding the value of the Dollar.  But today, the news was good- at least as far as the USD is concerned.  The Wall Street Journal leaked a document from the Bush Administration that mentioned tax cuts for households and businesses.  The aim of the tax cuts, ideology notwithstanding, is to provide a stimulus for the reeling economy.  As they say, what’s good for the US economy is good for the Dollar.  Reuters reports:

"Given the market’s perception that a (U.S.) recession is looking increasingly inevitable, tax cuts and any stimulus measures offered by the authorities will obviously bode well (for risk appetite) … It’s more positive for the dollar because there is a sense that it may help avoid a recession."

Read More: Prospect of US tax cuts boosts FX risk appetite

Last week, the Institute for Supply Management released the results of its monthly manufacturing survey, which fell to a four-year low.  Taken with testimony from bond expert Bill Gross, the picture is now quite bleak. In fact, economists are projecting that the US economy will slip into recession as soon as the first quarter of 2008; Gross believes that the economy is already in recession.  As a result, futures markets have already priced in a 75% chance of a 25 basis point rate cut and a 25% chance of a 50 basis point move by the Fed at its next meeting, scheduled for the end of January.  As expected, the Dollar is taking a beating in forex markets, as traders price in the effect of the rate cuts, which would create interest rate parity with the EU.  DailyFX reports:

The minutes from the last FOMC meeting confirmed that growth is the Fed’s primary concern at the moment. The deterioration in incoming economic data has forced them to lower their growth estimates for 2007 and 2008.

Read More: US Dollar Falls as Traders Consider 50bp Rate Cut for January

In Venezuela, the inflation rate for 2007 is estimated at 20%, a slight increase over the 17% growth in prices that was observed in 2006.  The nation, led by Hugo Chavez, plans to deal with inflation by dropping a few zeros from the currency’s exchange rate.  Currently, the official exchange rate is 2,150 Venezuelan Bolivars for every US Dollar.  Under the revaluation, the new official exchange rate will become 2.15 Bolivars/USD.  Critics charge that the change will not have any impact on inflation, especially since the market exchange rate implies a Bolivar that is three times less valuable than government rates.  Chavez retorts that the revaluation is only one part of a broader, more sophisticated strategy.  Down Jones reports:

The Central bank president had earlier in the year said the effect on inflation would be neutral, and most economists agree, but [Finance Minister] Mr Cabezas said "it’s definitely going to have a positive effect" on the government’s fight against price increases.

Read More: Chavez drops zeros to fight inflation

Last week, the Forex Blog recounted what happened across forex markets in 2007, in all of its drama. Now, we would like to offer a nice counterpoint, in the form of the major themes expected to dominate forex headlines in 2008, courtesy of Dow Jones. The list includes eight distinct themes, though there is some overlap.  Three of the themes pertain directly to the USD, which is the currency most worth watching in the upcoming year.  The fundamentals bode well for the Dollar; the economy has not suffered from the credit crunch nearly as much as economists feared; the cheaper currency has boosted exports; foreigners have proven surprisingly willing to finance the twin deficits.

Then, there is inflation, which has reared its ugly head in the US as well as abroad. Foreign Central Banks, especially in Asia, may have to tighten monetary policy in order to maintain price stability. Those countries with already-high interest rates, such as Australia and New Zealand, are expected to keep rates high.  The next theme, accordingly, is the carry trade, which should continue its run due to the aforementioned high interest rates.  Next is China, which will be watched on two fronts: its economy and its currency, both of which are expected to continue rising. 

The final two themes pertain especially to the Middle East: currency pegs and Sovereign Wealth Funds. As the Dollar declined in 2007, several nations in the Mid East mulled the possibility of de-linking their respective currencies from the Dollar, but thus far, the status quo has obtained.  Sovereign Wealth Funds also made a big splash in 2007 with several high-profile investments in the US, implicitly underscoring their their commitment to the Dollar.  They represent a growing force in global capital markets, and will be watched vigilantly in 2008.

View the Complete List Here

India is quickly becoming a major force on the foreign exchange reserve scene.  While India doesn’t fix its currency to the USD like China does, it still removes most foreign currency from circulation in order to mitigate against inflation.  As a result, its reserves have ballooned to nearly $300 Billion, having increased by $100 Billion this year alone.  India will now be faced with the same decisions that many other forex reserve hogs have been forced to reckon with, namely how to allocate its reserves. While India hasn’t weighed in prominently on the issue as China has, analysts will be watching closely.  The Economic Times reports:

Rate cut by the Fed in the US along with the positive perception prevailing about the emerging economies such as India has led to sharp rise in inflows, it said.

Read More: Forex Reserves to touch $300 bn by March 2008

When making predictions for 2008, it is useful to put things in perspective by assessing predictions made at this time in 2007.  With regard to the Canadian Dollar ("Loonie"), most  analysts predicted a rise, but all dismissed the possibility of parity with the USD.  Ultimately, the Loonie rose to 1.10 against the Dollar before ending the year just above parity. With this in mind, experts are predicting the Loonie will continue to appreciate in 2008, with forecasts ranging from modest to stellar.  Some analysts believe the Loonie will continue to ride the wave of high commodity prices, while others expect the currency to benefit from a general weakness in the US Dollar.  But if 2007 taught us anything, it’s that these predictions should be taken with a grain of salt. The CanWest News Service reports:

Gartman, who two years ago predicted the loonie would reach parity with the U.S. greenback, says the Canadian dollar is poised to rise even further, but on its own merits, and not because of a run on the greenback, which he suspects is already oversold on world exchange markets.

Read More: Loonie’s rise may continue in ’08, say experts

What analysts have been warning of for years has finally come to pass: the USD officially occupies a smaller portion of global foreign exchange reserves.  According to a recent IMF reports, the fraction of reserves denominated in Dollars has fallen from 66.5% to 63.8% over  the last year, with much of the difference offset by a proportional rise in the preponderance of the Euro.  Analysts first began sounding alarm bells as early as 2003, when the Dollar fell nearly 15% against the Euro.  However, it wasn’t until 2006, when China began to accumulate reserves at an ever-increasing rate as its trade surplus exploded while at the same time the USD was tanking, that commentators began paying attention. 2007 brought several anecdotal reports that foreign Central Banks were both passively and actively diversifying their reserves.  Now, it looks as though these were not isolated incidents, but instead part of a broader trend. AFP reports:

In recent months, several emerging-market countries, whose foreign currency reserves have ballooned as a result of such factors as high commodity prices and strong exports, have signaled their intention to further diversify their foreign exchange reserves to offset the US currency’s depreciation.

Read More: IMF says dollar losing ground in global forex reserves

With the books closed on 2007, analysts are looking ahead to 2008.  With regard to the Dollar, market sentiment is surprisingly upbeat, with expectations of a 5-10% appreciation.   In blogging circles, the word "oversold" has been cropping up. Commentators cite a mix of technical and fundamental factors in their reasoning. Some economists expect the US trade deficit to decline marginally in 2008 and GDP to grow at 2-4%. These fundamentals, they argue, support a higher Dollar valuation. The price of oil has been singles out as a pivotal input in the US economic forecast.  If the price declines by 20% or more, it could offset the still-unfolding housing crisis and provide much-needed support for the faltering economy.  he EU could also take steps to support a Dollar appreciation.  EU Government and Central Bank officials have voiced concern over the Euro’s rise, and could intervene on its behalf via a change in interest rates.  BloggingStocks reports:

"So far the ECB’s deeds have not matched their words, but one gets the sense the ECB will take actions to strengthen the dollar and weaken the euro in 2008."

Read More: Experts see mild dollar rally in 2008 if economy holds up