How 2007 Changed the Foreign Exchange Market
For the financial markets and the foreign exchange market in particular, 2007 was a year that gave everyone a much needed reality check. Over the past 6 years, the financial markets have become irrationally exuberant. Record low volatilities in the foreign exchange market sparked a vigorous appetite for risk, one that caused money market and state funds, which are suppose to be extremely conservative to be exposed to subprime risk. The hunt for yield and the belief that the good times would continue tempted many managers to look to increase their returns by investing in mortgage backed securities. The availability of cheap and easy money also led many mangers to leverage their bets which escalated their risk. Unfortunately the problems in the subprime sector blew up in 2007 and everyone learned the consequences of taking excess risk, the hard way. The lesson that money managers and investors learned in 2007 is to be more selective with their investments, be less exposed to risky assets and more conservative with leverage. For the foreign exchange market, this will have a direct impact on carry trades. The primary reason why carry trades have thrived over the past few years is because volatility fell to a record low. They have now doubled from their June 2007 levels which means that carry trades will no longer be easy one-way bets. The multi-decade highs that we have grown accustomed to will be much more difficult to achieve as everyone becomes more careful with their investments and strives not to repeat the mistakes made in 2007. Also, with the US dollar falling to a record low against the Euro, currencies have become water cooler talk. The general public has become much more aware of how currencies can affect their daily way of life and this is a lesson that will remain with them for the foreseeable future. Countries around the world and the financial markets have become much more intertwined, or in other words, globalization has also been taken to another level this past year. Sovereign wealth funds have become a force to be reckoned with. Between the U.A.E, Singapore, Norway, Saudi Arabia, Kuwait and China, there are as much as $2 trillion to spend. Their shopping spree has led to some of the biggest deals this year with the latest being Singapore’s $4.4 billion investment into Merrill Lynch. Saudi Arabia also just announced that they are setting up their fund which is a big reason why we expect this trend to continue. As many of these government funds invest in US financial firms, it will help the US dollar and bring the world much closer together. The FX market is closed on Tuesday and Wednesday. Although there are some housing and manufacturing numbers on Wednesday, there are no major US reports until Thursday.

ECB President Trichet Voted Financial Time’s Person of the Year
The Financial Times voted ECB President Trichet as their Person of the Year and we at DailyFX have always loved Trichet for his candid no nonsense comments on monetary policy. He has never wavered to political pressure and has always tried to prepare the markets months in advance for any potential change to interest rates. As the ripple effects of the US subprime problems caused a major liquidity crisis in the credit markets, the ECB was the first central bank to respond with a massive liquidity injection. According to the FT, for a central bank that is not yet 10 years old, the ultimate compliment was paid when the venerable US Federal Reserve and Bank of England followed suit. Trichet’s reputation was the only one to be enhanced by the latest turmoil. This morning, he continued to remind the markets that the ECB will be focusing on inflation and their desire to contain it will not be distracted by the interest rates cuts from the US and Federal Reserve. When Trichet speaks, we all listen and that says a lot for a central bank who’s credibility has been questioned repeatedly since their inception.

British Pound Falls to Record Low Against the Euro
In the fifth consecutive day of weakness, the British pound fell to a record low against the Euro and a 4-month low against the US dollar. With most traders out for the holidays, the trends that began last week have continued well into this week. No one is willing to stick their hand out and start picking a bottom in the British pound this late in the year. Instead many traders are probably happy to end the breakeven and will take this opportunity to collect themselves before start over again in January. As UK economic data continues to show signs of weakness, there are no buyers left in the market. This morning, Hometrack reported 0.3 percent decline in house prices in the month of December, which is the biggest drop in 3 years. They also predict that the number of closings will fall by 17 percent and that prices will rise by just 1 percent next year. The housing market has been the back bone of UK growth for many years and now that this sector of the economy is crumbling, growth could suffer greatly in 2008.

Rally in Stocks Drives the Yen Lower and Australian, New Zealand and Canadian Dollars Higher
Since Friday, the Dow has rallied 300 points and that strength has helped to take the Australian, New Zealand and Canadian dollars higher against both the Japanese yen and US dollar. Commodity prices are basically unchanged on the day which indicates that the fluctuations of these currency pairs are largely driven by risk appetite. Of course that too is distorted given the lack of liquidity across the financial markets today. Either way, the Dow and USD/JPY are breaking their 100-day SMA which suggests that these gains should continue for the remainder of the week. There are Japanese data scheduled for release Monday and Tuesday night. These reports which include the BSI manufacturing index, the corporate service price index and supermarket sales will not be market moving. Also, the BoJ minutes will simply reinforce what the market knows already, which is that interest rates in Japan will remain low for a very long time.

Kathy Lien is the Chief Currency Strategist at FXCM.