MARKET OBSERVATIONS

ED PONSI

Currency Outlook 2008

46 FEBRUARY 2008
 Ed Ponsi shares his views for the major
currencies as we trade into 2008. Which
currencies will do well and which will
falter? Find out here!
2
007 was an exciting and vibrant year for traders in the
global currency markets. The big highlight of the first half
of the year was the ‘carry trade’ and traders who shorted
the Japanese yen against higher yielding currencies enjoyed tre-
mendous appreciation while collecting interest along the way.
The carry trade finally fell apart in August, but not before trad-
ers who took advantage of this strategy cleaned up. The weak
U.S. dollar was a constant theme, as the beleaguered buck fell
to 2.000 against the British pound for the first time since 1992
and reached parity versus the Canadian dollar for the first time
since 1976. The Canadian currency and the Australian dollar
were rock stars in 2007, buoyed by a relentless rally in the prices
of gold, oil, and other commodities. The euro chugged higher
against most currencies, much to the dismay of a variety of Eu-
ropean financial and political officials.
So much for the past – what does the future hold for currency
traders? A number of new trends were initiated late last year
that could extend well into 2008. The British pound, a stout
performer in recent years, cracked badly in December as U.K.
housing prices began to slide. The Japanese yen is enjoying a
resurgence that may extend well into this year and beyond. Even
the woeful U.S. dollar has recently flexed its muscle. Where will
we go from here? Let’s take a look at some possible scenarios…
The U.S. Dollar
When the U.S. dollar gained strength in December after finding
support just before reaching 1.50 against the euro, some pundits
called a bottom and declared that 2008 would be the ‘Year of the
Dollar.’ After all, if supermodels like Gisele Bundchen do not
want to be paid in USD, then the greenback must have reached
a bottom, right? Not necessarily; in fact, it could just be that
the supermodels are smarter than the analysts! The important
point that these analysts are missing is the correlation between
the omnipresent ‘credit crunch’ and the greenback. Keen mar-
ket observers may have noted that recent seizures in the credit
markets have been accompanied by rallies in the U.S. dollar. In
fact, in August of last year, when the extent of the crisis first be-
came apparent and equities markets began to suffer, EUR/USD
plunged from 1.3900 to 1.3300 as the greenback sprung to life.
This dollar rally lasted until Ben Bernanke and the U.S. Federal
Reserve unexpectedly cut the discount rate by 50 basis points on
August 17, simultaneously restoring confidence in credit mar-
kets and sending the USD into a tailspin.
Between mid-August and mid- December, the EUR/USD cur-
rency pair climbed all the way from 1.3300 to just below the
huge psychological resistance level of 1.5000. This demolition
of the dollar continued until – you guessed it – LIBOR climbed
through the roof in December, indicating that banks had once
again become uneasy about lending to one another. This tight-
ening of credit was accompanied by another USD rally, with
EUR/USD falling back from 1.4900 to the 1.4300 area. When
some of the world’s most prominent central banks came togeth-
er in December in a historic bid to provide liquidity, the dollar’s
slide resumed.
Where does this leave the USD for 2008? While the impact
of the credit crunch is far reaching and may be far from over,
no crisis lasts forever. Fear is never a permanent condition and
any bounce that the U.S. dollar might enjoy due to credit and
lending issues is bound to be temporary. The United States still
runs huge trade and budget deficits, faces a weakening housing
market and a possible recession, and a has a central bank that
has already cut interest rates repeatedly from a peak of 5.25%.
Fed Chairman Ben Bernanke has pledged to take ‘substantive
additional action’ to keep the U.S. economy afloat, indicating
a much lower base lending rate, with some estimates showing a
3.00% Fed Funds rate this year. These aggressive cuts in the Fed
Funds rate should keep the USD on its back foot for the fore-
seeable future. Taking these facts and issues into consideration,
look for continued weakness in the U.S. dollar in 2008.
The Euro
No currency is immune to a global slowdown and the euro is no
exception. If the U.S. and U.K. are facing deep trouble, none
of the major world economies will escape unscathed. However,
this single currency should outperform its peers due to the Euro-
pean Central Bank’s hawkish stance against inflation. The ECB
is mandated to ensure price stability, which it defines as keeping
euro zone inflation equal to or below 2 percent in the medium
term. Euro zone inflation is currently at 3.1 percent, a six-and-
a-half-year high. While inflation should moderate as the U.S.
and U.K. economies slow, ECB President Jean Claude Trichet
said on January 10, 2008 that the bank will act ‘preemptively’
if it sees signs of a wage-price spiral. When asked for his views
on the economy for 2008, he said: “We see again as a reference
scenario growth which remains significant and which is around
our potential, which is to say, of about 2 percent.”
The real bright spot for the euro is its continued march toward
acceptance as a reserve currency. According to the International
Monetary Fund, the euro’s share of known foreign exchange
holdings rose to 26.4 percent in the third quarter of 2007, up
from 24.4 percent in the third quarter of 2006. The euro has
FEBRUARY 2008 47
 MARKET OBSERVATIONS
steadily gained ground against the dollar in international official
foreign exchange reserves – an amazing fact when you consider
that euro is a currency that has only been in use for nine years.
Despite the growth projections and hawkish rhetoric, Europe is
not an island and will be affected by a possible global slowdown.
Expect the ECB to join the rate cut parade in 2008, but to a
much lesser degree than in the U.S. and U.K. – a modest easing
of lending rates to 3.5% could be in the cards later this year. The
euro should climb versus the U.S. dollar for the fifth year out of
the past six, with the EUR/USD currency pair rising to 1.5500
in 2008.
The Great Britain Pound
While strong for most of 2007, the British pound imploded at
the end of the year. It fell hard against the euro and the U.S. dol-
lar. The currency has fallen out of favor because the U.K econo-
my’s problems are beginning to look more and more like those
of the U.S., including a weakened housing market, pressures on
financial institutions and slower consumption. Also, like the
U.S., the U.K. has seen persistent credit growth, a major in-
crease in housing prices (even more dramatic than in the U.S.), a
low level of private savings and a sizeable current account deficit
(5.7 per cent of GDP in the third quarter of 2007).
48 FEBRUARY 2008
Faced with falling real estate values, consumers pulled back; it
was announced on January 18 that U.K. retailers suffered their
worst Christmas in 13 years in 2007. Retail sales fell 0.4 per cent
in December, usually the key month for shopping, much worse
than the 0.2 per cent increase that economists had forecast.
The severity of Britain’s downturn was first made evident by
the demise of mortgage lender Northern Rock, which turned
to the Bank of England for emergency funding in September.
This sparked the country’s first bank run in more than a century.
Britain’s central bank will be forced to lower its key interest rate
to spur growth, a process that has already begun and will con-
tinue well into the New Year. Expect the Bank of England to
cut its key rate to 4.5% in 2008, as the reality sinks in that U.K
housing prices, which have risen for thirteen consecutive years,
are finally due for a pullback. Watch for the British pound to
slide to 1.85 against the U.S. dollar before stabilizing.
The Japanese Yen
Off to a strong start already in 2008, the Japanese yen may have
more upside potential than any other major currency. Last
year, we saw a strong correlation between world equity markets
and movements in yen currency pairs, especially EUR/JPY and
GBP/JPY. Sharp drops in the S&P 500 and other major stock
indices often coincided with major rallies in the Japanese cur-
rency. This so-called risk aversion trade, which consisted of sell-
ing stocks and buying the yen, could be on again in 2008 as the
sub-prime mess continues to damage investor confidence and
threaten global growth.
While overseas weakness will likely hurt Japan’s exports and its
economy, its currency could come out a winner just the same.
The yen may strengthen to 102 per dollar and beyond as Jap-
anese companies convert more cash held overseas into yen to
safeguard against losses in other currencies. Here is the ques-
tion that will be on every trader’s mind – at what point will the
Bank of Japan step in and weaken the yen if the currency gains
too much, too quickly? In late 2003, the Bank of Japan drew
a line in the sand at 105 versus the USD, but now competitor
China has allowed the yuan to strengthen, giving the yen some
breathing room. Expect the Bank of Japan’s overnight call rate
to remain at 0.5% throughout the year. When world economies
were growing by leaps and bounds and central banks were con-
sistently raising key interest rates, traders loved to short the yen
and the so-called ‘carry trade’ was the toast of the town. Now
that the shoe is on the other foot, expect to see a big year from
the Japanese yen.
The Australian Dollar
Like the Canadian dollar, the Australian dollar is heavily impact-
ed by commodities prices. One major difference between these
two commodity currencies is location. While Canada borders
the U.S., a giant with a weakening economy, Australia is located
closer to Asian countries that feature booming economies. Chi-
na’s meteoric growth rate is expected to dip slightly to 10.2% in
2008, according to the Chinese Academy of Sciences. Cities are
springing up all over China, and many of the base metals that
are needed for this construction are coming from Down Under.
While other central banks are in a rate-cutting mode, the Reserve
Bank of Australia is mulling rate hikes. In fact, the minutes from
the RBA’s December 4 meeting contained the comment, “absent
the changes in market yields since the November meeting, there
would have been a strong case on domestic grounds for a rise in
the cash rate at this meeting.” In other words, RBA governor
Glenn Stevens and company would have raised the benchmark
lending rate to 7.00% in December if it were not for the credit
issues currently plaguing the world’s banks. Then on January
18, 2008, Stevens said in a speech to business executives in Lon-
don that the bank remained concerned about prices, even after
raising its official interest rate twice in 2007. The Consumer
Price Index report for the fourth quarter is likely to show the an-
nualized rate of inflation rose to three percent or higher – above
the RBA’s two to three percent comfort zone.
Unless and until China’s amazing growth story changes, expect
the Australian dollar to outperform most major currencies this
year. Do not be surprised if the ‘Aussie’ takes a run at parity
versus the U.S. dollar in 2008, as the AUD/USD interest rate
differential widens, launching a new carry trade with the green-
back as the funding currency.
The Swiss Franc
Another low-yielding currency that might benefit from the tur-
bulence in world markets is the Swiss franc. Much like the Japa-
nese yen, the franc tends to perform well during times of risk
aversion – not only because of its status as a funding currency
for the carry trade, but also due to its status as a safe haven cur-
rency. In many ways, Switzerland and the SNB find themselves
in a predicament similar to that of Europe and the ECB, regard-
ing growth and inflation. In January, the president of the Swiss
National Bank, Jean-Pierre Roth, warned of the threat of rising
inflation, along with possible risks to the Swiss economy.
The SNB’s official forecast made in December called for eco-
nomic growth to slow to approximately 2 percent next year
from slightly above 2.5 percent in 2007 as the credit crisis and
its fallout hits global growth and Swiss exports. Switzerland is
also feeling the pain of the sub-prime debacle. Swiss-based bank
UBS AG, the world’s largest wealth manager, has made $14.5
billion in credit-related write-downs so far and is expected to
post additional losses. Overall, expect a good performance from
the Swiss, reaching parity versus the USD as risk aversion reigns
in 2008.
The Canadian Dollar
While this currency has been in the driver’s seat due to its status
as a commodity currency, Canada is in the unfortunate posi-
tion of having the U.S., a country that may be about to enter a
recessionary phase, as the destination of over 80% of its exports.
Exports to the U.S. account for about 25% of Canada’s overall
GDP, this means that any economic slowdown in the U.S. could
have a dramatic impact on Canadian growth.
Additionally, expected weakness in the U.S. economy has caused
crude oil prices to fall from a peak near $100, and a reduction in
the consumption of oil, accompanied by a sharp drop in price,
could weigh heavily on the ‘Loonie.’ One more negative fac-
tor is the recent strength of the currency itself, which has hurt
the manufacturing sector. Canada’s economy shed over 18,000
jobs in December and Canadian manufacturers lost 33,200 jobs
that month, bringing the industry’s total decline for 2007 to
131,600, a 6.2 percent drop from the previous year.
One bright spot is benign inflation; core inflation, which ex-
cludes volatile items, slowed to 1.6 percent in November and
is expected to stay below the central bank’s 2 percent target
through 2008. Expect the Bank of Canada to reduce interest
rates to 3.50% this year, and watch for the Canadian dollar to
rise back to 0.95 USD in 2008.
Ed Ponsi is the President of EdPonsi.com and FXEducator.com. He is a
dynamic public speaker who has appears regularly on CNBC, CNN and
Fox Business Network. His book, “Forex Patterns and Probabilities”, is now
available at http://www.edponsi.com and from major book retailers. An
experienced professional trader and money manager, Ed has advised
hedge funds, institutional traders, and individuals of all levels of skill and
experience. Ed’s DVD series, “FXEducator: Forex Trading with Ed Ponsi” is
available at www.fxeducator.com and from select distributors world-
wide. For more information, email us at info@fxeducator.com
FEBRUARY 2008 49