US Dollar – The Odds Are Against a Major Comeback for Now
The US Dollar tumbled significantly last week amidst heightened risk aversion following the assassination of former Pakistani PM Benazir Bhutto. Indeed, the greenback was clearly not even close to being the “safe haven” of choice, as the Euro and Swiss franc saw the greatest gains. Meanwhile, US data has been broadly mixed, with consumer confidence surprisingly proving to be more optimistic, while production and housing figures have been generally disappointing. Nevertheless, with fed fund futures pricing in a 90 percent chance of a 25bp rate cut by the FOMC on January 30, pure interest rate differentials raise the risk of further declines in the greenback. Add to that the geopolitical turmoil that has re-emerged and the low liquidity we see so often around this time of year, and the situation is ripe for softness in the US dollar.

Looking ahead to this week, many of these issues will remain pertinent, as housing data, ISM manufacturing, ISM non-manufacturing, and employment reports – including the market-moving non-farm payrolls release – are all anticipated to weaken. Moreover, the IMF reported over the weekend that international foreign exchange reserve holdings of the US Dollar dropped to 63.8 percent in Q3 from 66.5 percent a year earlier, as central banks increased their holdings in the Euro to 26.4 percent in Q3, up from 24.4 percent a year ago. This is a slow trend that we will likely see continue, as the Euro-zone is a major player in the international arena when it comes to the financial markets and trade. Now, this doesn’t mean the greenback is destined to become worthless in 2008, but as Technical Strategist Jamie Saettele said Friday in his Daily Technical Report, EUR/USD may be on its way to 1.50 and beyond. Currently, the odds are against the beleaguered dollar, and until the FOMC takes a more firm monetary policy stance that does not waver in the face of the market’s demands, or until other central banks (like the ECB) jump on the rate-cut-bandwagon, additional losses may be on the way.

Euro Rallies Strongly on Renewed Speculative Interest
The euro was among the best performing currencies through the past week of forex trade, as broader US dollar sell-offs left the EUR/USD significantly higher through Friday’s close. A relatively empty economic calendar left the singe currency to trade mostly off of broader market flows, and it seems as though it was one of the major beneficiaries of fresh anti-greenback sentiment. General market illiquidity only exacerbated euro rallies, and the singe currency seemed to force big-figure moves against the greenback with ease. The little European economic data released improved the euro’s prospects—especially as Euro Zone Retail PMI numbers were broadly improved through the month of December. A very marginal disappointment in German Consumer Price Index figures had little effect on the euro, and a year-over-year inflation rate of 2.8 percent hardly rules out further European Central Bank hawkishness through the medium term. Given official inflation targets of 2.0 percent, the ECB will clearly remain on the defensive if price pressures continue to escalate above their stated comfort zone. Given falling interest rates for many major forex counterparts, stable euro yields will clearly boost the single currency’s status in the FX world.

The coming week will likely bring further clarity to overall interest rate expectations, with key German Unemployment and Euro Zone CPI figures due through Thursday and Friday’s price action. The New Year’s holiday will likely make for quiet but choppy trading through the very short-term, however, as most major trading desks close up shop until the first full week of 2008 trading. Economists predict that German unemployment continued to decline through the month of December, with the headline jobless change forecast at a respectable 35,000 pace. The seasonally adjusted unemployment rate is subsequently forecast to fall to fresh 14-year lows of 8.5 percent, and such a result would certainly bolster outlook for consumption in Europe’s largest economy. Otherwise, markets will to Friday’s Euro Zone CPI data and the infamous US Nonfarm Payrolls release to drive euro volatility. Any disappointments in EZ CPI or particularly strong US NFP figures could make the EUR lose its luster as the perfect anti-dollar trade. As such, it will be important to watch both reports to gauge potential directional bias in the EUR/USD and other major pairs.

Yen Gains on Return to Risk Aversion, Ignores Poor Spending Data
The Japanese yen gained for the second consecutive week of forex trading, as a pronounced flight to safety forced noteworthy rallies in the risk-linked currency. Such gains were exacerbated by generally uninspired performance in the US Dow Jones Industrial Average, while the yen largely ignored disappointments in domestic economic data. Notables included a sizeable 27.0 year-over-year drop in domestic Housing Starts through the month of November, while a dismal 0.6 percent year-over-year drop in Overall Household Spending likewise dimmed outlook for domestic consumption. Yet limited reactions to the releases suggest that markets will continue to turn a blind eye to historically market-moving economic reports. Risk sentiment seems to be by far the strongest influence on the Japanese currency. The 50-day rolling correlation between the USD/JPY and the S&P 500 Volatility Index (VIX) has reached its most strongly negative levels in at least 17 years—underlining sensitivity to movements in the US equity market “fear index”. Thus outlook on the yen will almost completely depend on broader US dollar price action and, more importantly, the performance of risky asset classes.

It will be critical to watch whether risk sentiment improves in the week ahead, but volatility may remain muted on another holiday-shortened week of trading. Low volatility has recently brought Japanese yen declines, and it will be interesting to see whether this will be the case in the days before and after New Year’s celebrations. Japanese markets will be especially quiet through year-end trading, as the days from December 31 – January 3 will be official bank holidays and major exchanges will remain closed. The domestic economic calendar is unsurprisingly empty through the days ahead, and the next significant economic event risk will be seen in the week of January 6 – 11. From a technical perspective, the USD/JPY may look to rally on a hold of nearby support levels. According to our Technical Analyst Jamie Saettele, the USD/JPY is likely to reach 115.00 in the days ahead. Click to read our USD/JPY Technical outlook.

Cable May Break Above 2.00, But Not for Long
The British Pound managed to gain some footing last week, but that was due primarily to broad weakness in the US Dollar, as Sterling’s 0.6 percent appreciation was relatively mild compared to that Euro (2.4 percent), Swiss Franc (2.6 percent), and even the low-yielding Japanese yen (1.6 percent). The odds are stacked against the GBP/USD pair in 2008, and the past week’s economic data highlights why: though UK housing equity withdrawals during Q3 surprisingly rose £10.5 billion – helping to explain how consumption managed to remain resilient during that period – nearly every housing market indicator suggests the sector is in for a major slowdown. The British Bankers' Association reported that mortgage lending slumped to £4.3 billion in November, down from £4.8 billion during the month prior. This comes as little surprise as lending standards tighten and borrowing costs remain high. Furthermore, properties remain unaffordable in the UK, despite the fact the prices have started to recede. In fact, house prices (as measured by Nationwide Building Society) fell 0.5 percent in December, marking the second consecutive month of declines and dragging the annual rate to a one-and-a-half year low of 4.8 percent. With these factors unlikely to subside in the near-term, demand for homes and price growth should continue to slow and take a toll on GDP.

Looking ahead to this week, UK economic data is expected to tell the same old story: economic expansion in the country is deteriorating. However, as we mentioned in the US dollar section, the greenback may remain a laggard this week, which creates an opportunity for Cable to garner the strength to break above 2.00. Nevertheless, the fundamentals of the situation are likely to play out eventually for the GBP/USD as they have already for the EUR/GBP pair. UK PMI figures are forecasted to reflect slowing in the manufacturing, services, and construction sectors in December as tight credit market conditions, volatility in the equity markets, and high energy prices weigh on consumers and businesses alike. With these situations highly unlikely to be alleviated in the near-term, the prospects for economic growth in early 2008 isn’t exactly optimistic. As speculators shift their focus away from the beleaguered US dollar, Cable will likely rack up losses once again.

Boris Schlossberg is a Senior Currency Strategist at FXCM.