Dollar – Any More Fireworks in 2007?
As we wrote on Friday, “The FX dealing world is quietly wrapping up business for 2007. Next week, with Japan closed for Monday and Europe and North America closed for Christmas, trading is likely to remain moribund. Unlike the past few years when low liquidity conditions often resulted in massive volatility, this year most of the position squaring has been done and unless we get some unexpected geo-political or financial in the next two weeks it looks like range, range, range for the rest of 2007.”

On the economic front the data was decidedly mixed this week with balance sheet items such as TICS and Current Account showing marked improvement while business demand slowed. Both Empire and Philly missed badly with Philly registering its first negative read in a year. Meanwhile weekly jobless claims climbed to 346K uncomfortably close to the 350K figure. All in all US data suggested that a slowdown was no doubt occurring but hard evidence of actual economic contraction is not present yet.

Next week the holiday shortened schedule will have little of interest on the calendar, but Thursday’s Durable Goods number could be important. After contracting for three months in a row the market is looking for a bounce. If one does not materialize fears that a serious slowdown in demand is near could escalate putting pressure on the greenback.

Euro – Tough Talk, But Not Walking the Walk.
European data this week was generally positive and was followed by consistently hawkish rhetoric from ECB Chief Jean-Claude Trichet. But as we noted on Friday, “On the economic front EZ data managed to offset itself with German Import prices rising more than expected giving further credence to ECB’s argument that price pressures are mounting. On the other hand, French consumer spending dropped much sharper than forecast, declining –0.1% versus consensus calls of a 0.6% gain. The news once again underscores the dichotomy between ECB’s tough talk and the reality of lackluster EZ consumer demand which is almost certain to keep Mr. Trichet and company on the sidelines at least through the first month of 2008. “

Next week the calendar is barren save for PMI data on Friday as most of the region will be on a prolonged holiday. Generally the news flow should be slow and EUR/USD is likely to be contained in the 1.4300-1.4500 range for most of the week. With heavy duty volatility in the pair behind them, most traders appear to be content to let 2007 expire quietly before staging any directional breakouts.

Japanese Yen Eases Further as BOJ Bias Turns More Dovish
The Japanese yen fell against the US dollar for the fourth consecutive trading week, as both the Bank of Japan and the government downgraded their outlooks for the economy. Indeed, after voting unanimously to leave rates steady at 0.50, the BOJ said that the pace of growth may “slow for the time being,” as weak profits hurt wage growth and consumption, while stricter rules for building permits caused housing starts to plummet. Meanwhile, the government lowered its forecast for economic growth this year to 1.3 percent from 2.1 percent.

The Japanese yen has gradually weakened against the greenback through December, and the recent consolidation of USD/JPY within an ascending triangle creates the potential for a breakout to the upside. Furthermore, according to Technical Strategist Jamie Saettele’s Elliot Wave analysis, USD/JPY is likely to rally towards 114, where falling trendline resistance sits. Business sentiment in Japan is likely to falter in Q4 as a stronger yen hurts exporters and a global credit crunch increases borrowing costs and damages prospects for growth worldwide. In fact, the BOJ’s Tankan index of manufacturer sentiment fell more than expected in Q4, to 19 from 23, and over the past two years, large shifts in the Tankan reading tend to coincide with movements in the BSI. The performance of businesses in Japan is of great concern to the BOJ, as the bank’s governor, Toshihiko Fukui, said last week that he was concerned falling profits would hamper wage growth and put a dent consumer spending. Nevertheless, neither of these factors have shown sharp improvements in recent months, so if anything, the greater concern for Fukui may be that he will be prevented from pursuing further rate normalization before he leaves his post at the central bank early next year. Indeed, the most recent policy meeting resulted in a unanimous vote to leave rates steady, as even the sole hawk on the monetary policy board, Atsushi Mizuno, backed off in light of the tumultuous credit market conditions and its threat to the economies of the US, UK, and Europe. Furthermore, with the BOJ having downgraded its assessments of the economy for the first time in three years, and with inflation showing few signs of building, the markets are actually starting to consider the potential for a rate cut before Fukui’s departure. As a result, a disappointing BSI release may only lead this speculation to be exacerbated among traders and push USD/JPY higher.

Cable Breaks Major Trendline Support, Likely to Fall Further
The British pound tumbled through trendline support and the psychologically important 2.00 level last week, as the release of the minutes from the Bank of England's December meeting revealed a 9-0 vote to cut rates by 25bp to 5.50 percent as "market conditions had deteriorated further" and turmoil in the financial markets had increased the downside growth and inflation risks. Indeed, the BOE said that the housing slowdown was "more pronounced than expected" and that they had grown more concerned given the scale of large bank losses. However, the monetary policy committee signaled some hesitance to cut rates further, as they noted that this was a "preemptive" move and that a larger rate cut would "fuel inflation risks." Nevertheless, if rates remain restrictive, banks continue to rack up massive losses, and inflation measures ease, there is little doubt the BOE will consider cutting again in Q1 2008.

Looking ahead to this week, thin holiday trading may leave GBP/USD either trading sideways or reacting violently to news flow. Economic data out of the UK will be light, but any major headlines about the US economy or the credit crunch could spark volatility. The only UK figures scheduled to be released come at the end of the week, when housing equity withdrawals are anticipated to drop while house prices are expected to slip further, boding ill for consumption growth and raising the risks that the BOE will consider cutting rates again in January. As a result, Cable could continue to fall.

Swiss Franc Continues to Falter
Last week, the U.S. dollar continued to rally against the Swiss franc on evidence that the U.S. consumer is still spending enough to prevent the U.S. economy from sliding into recession. More specifically, from December 14 to December 22, the U.S. dollar gained nearly 1.4 percent against the Swiss franc, trading from a low of 1.1405 to a high of 1.1593, reached during the early hours of this Friday’s trading session. Yet, despite the losses against the U.S. dollar the Swiss franc traded higher against both the euro and the pound. Typically, many foreign investors repatriate their money at the end of the year and we believe many carry traders were forced to cut holdings of higher yielding currencies funded by borrowing in Switzerland.

While the U.S. Federal Reserve has been busy cutting interest rates to prevent a wave of payment defaults in the U.S. subprime sector to spread across the world’s largest economy, the Swiss National Bank has been clearly more concerned with inflation than with growth. This week, the Federal Statistics Office said in a statement that prices for factory and farm goods as well as imports increased 3 percent from a year earlier after gaining 2.7 percent in October. Economists expected an increase of just 2.9 percent, according to the median estimate in a Bloomberg News survey.

Next week, the economic calendar for Switzerland is relatively quiet with exception for the Swiss KOF survey release. Business sentiment in Switzerland is expected to soften to 1.98 in December from 2.02 during the prior month, according to a Bloomberg survey. However, we don’t think the decline will have a measurable impact on the Swiss National Bank economic expectations for 2008. According to interest rate futures for deposits denominated in Swiss francs, traders are clearly pricing two more rate hikes in 2008. While the overnight interest rate pays 2.6 percent, the 3 month rate pays 2.78 percent, the 1 year Libor rate 2.96 percent and the 10-year note pays more than 3.32 percent. If those rate hikes do happen, the additional monetary tightening should provide further support to the Swiss franc and make the Swiss currency less attractive as funding currency for carry trades.

Boris Schlossberg is a Senior Currency Strategist at FXCM.