How Did the Dollar Trade in 2008?

It has been an exceptionally active year in the foreign exchange market as currency volatilities hit record highs. In the first half of the year, everyone was worried about how much further the dollar would fall but in the second half of the year the concern became how much further the dollar would rise. After hitting a record low against the Euro in the second quarter, in the beginning of the fourth quarter, the US dollar actually surged to a 2 year high. From trough to peak, the dollar index rose more than 23 percent in 2008.

3 Themes for 2009

The US economy and the dollar’s fate in the years ahead could be determined by what happens in 2009. We are focusing on 3 big themes that will impact the US dollar and each of these themes encompasses a lot.

1. Will there be a U or L Shaped Recovery?

The US is in recession and the slowdown is expected to deepen in 2009. Before a recovery is even possible, the economy has to work through more weakness and negative surprises. Non-farm payrolls declined by 533k in November, sending the unemployment rate to a 15 year high of 6.7 percent. With many US corporations forced to tighten their belts, the unemployment rate could rise as high as 8 percent in 2009. We expect this to happen because over the past 50 years on average, recessions have boosted the unemployment rate by 2.8 percent. When the current recession started in December, the unemployment rate was 5.0 percent. If you tack on 2.8 percent to that level that would put the unemployment rate at least 7.8 percent.

Non-farm payrolls could double dip, just as it has in past recessions. In this case, we would expect a rebound followed by another sharp loss that rivals November’s job cuts. A rise in unemployment spreads into incomes, spending and then usually leads to more layoffs. We need to see this toxic cycle end before we can see a recovery. Consumer spending has already been very weak and the trade deficit is widening as the dollar strengthens. As the 2 primary inputs into GDP, we expect fourth quarter growth to be very weak. The strength of the US dollar in Q3 and for most of Q4 will also take a big bite out of corporate earnings, leading to disappointments for the stock market. This is why we expect more weakness in the US dollar and the US economy in the first quarter of 2009. However towards the middle of the second quarter, we may begin to see the US economy stabilize as it starts to reap the benefits of Quantitative Easing and President Barack Obama’s fiscal stimulus plan. New Administrations usually hit the ground running and as such we fully expect the rest of the TARP funds to be tapped shortly after his inauguration. The shape of the US recovery will have a big impact on the price action of the US dollar but there is no question that the path to a stronger dollar will be through a weaker one.

The following chart illustrates how non-farm payrolls double-dipped during the 2001 recession.



Although we expect the US economy to start its slow recovery in the second half of 2009, GDP growth next year will still be negative. Retail sales and non-farm payrolls will be particularly ugly in the first quarter, but we are optimistic that monetary policy and fiscal stimulus will begin to help the economy. The record decline in mortgage rates should also help to stabilize the housing market in 2009. Something between a L and U shaped recovery is likely.

2. What Matters More to the Dollar - Safety or Yield?

The dollar’s rally in the second half of 2008 has been largely driven by risk aversion, deleveraging and repatriation. In other words, despite the next to nothing yield offered by dollar denominated investments, a flight safety into US dollars and government bonds has kept the greenback from collapsing against other currencies like the British pound, Canadian and Australian dollars. The concern for safety was so high that investors were willing to take negative yields just to park their money with the US government. A bubble is brewing in the Treasury market and any improvement in risk appetite will take the market’s focus away from safety and back to return on money at which time ultra low interest rates could become a detriment for the US dollar. The dollar’s performance against other currencies would be contingent upon growth in the rest of the world. For example, if the UK economy is in the process of recovering, demand for yield and the prospect of return could send the GBP/USD higher, but if there is a prolonged recession in the Eurozone, then the Euro may no longer be the flavor of the month.

3. Compression in Interest Rates and Volatility

Volatility in the currency market also hit a record high in 2008 but in 2009 we expect the volatility to compress as interest rates around the world converge. Much of the volatility this past year has been spurred by speculation about how much various central banks would cut interest rates. As they run out of room to ease, we may stop seeing monetary policy surprises which can eventually lead to stabilization for carry trades. Don’t expect this to happen in the first quarter however as many central banks are still expected to cut interest rates. The Fed’s rate cuts have long been a big driver of market volatility and now that risk is off the table. When the monetary and fiscal stimulus start to impact the US economy, the market may actually start talking about a rate hike in the US. Interest rates cannot remain at zero forever, especially if inflation starts creeping higher in the second half of the year.

Is there a Risk of Deflation?

Deflation is much more of a problem for the US economy than inflation. Since oil prices are more than 75 percent off their highs. As a result, we have seen either flat or negative consumer price growth every month between August and November. The December numbers have yet to be release, but there is no reason to expect CPI to turn positive. Since the beginning of the year annualized consumer price growth has fallen from 2.1 to 1.1 percent. The US economy has not officially hit deflationary conditions, but with commodity prices continuing to fall and consumer demand slumping, deflation will become a greater risk than inflation in the first half of 2009. However this may change in the second half as Quantitative Easing, fiscal stimulus and hopefully a weaker currency boosts inflation.

Time for Quantitative Easing

US interest rates have fallen 400bp from 4.25 percent to 0.25 percent in 2008. For most people, interest rates at 0.25 percent are as unattractive as zero interest rates. With US rates pretty much at zero, the Federal Reserve has informally adopted its own version of Quantitative Easing. Some people may even argue that the Fed has been pursuing this strategy for months now. In conjunction with the Treasury department, the Fed has doubled their balance sheet in the past 3 months to more than $2 trillion. They have done this by purchasing direct equity investments in banks, easing standards on commercial paper purchases, made efforts to relieve institutions of their toxic asset-backed securities and are now considering buying Treasury bonds and agency debt. By buying these assets, they are adding money into the financial system. Like the Yen, Quantitative Easing exposes the US dollar to significant downside risks because the Federal Reserve is basically printing money and using that money to flood the market with liquidity, eroding the value of the dollar in the process. However it is a step that the central bank needs to take to stabilize the US economy and to prevent a deflationary spiral. The central bank will not be worried about a weak currency and will in fact welcome one because they know that a weaker currency is like an interest rate cut in many ways because it helps to support and stimulate the economy.

Technical Outlook for the Dollar Index

As indicated in the following chart, the US dollar rallied significantly in the second half of the year. Between June and November, the dollar index rose more than 25 percent. However the rally hit a brick wall in the month of December, when it plunged 12 percent. Since then it has recovered modestly, but it is hovering below stiff resistance. Not only is there the 38.2 percent Fibonacci retracement above current levels, but that also coincides with the 100-day Simple Moving Average. If the dollar index breaks above 81.70, there is scope for a much sharper gain, but the combination of a head and shoulders pattern in formation, Fibonacci and Moving Average resistance suggests that the odds are skewed towards more losses than gains in the beginning of 2009.



Euro 2009 Forecast

How Did the Euro Trade in 2008?

Exactly one year ago, the Euro was trading at approximately 1.47 against the US dollar, 5 percent higher than current levels. In 2008, this type of move is considered mild especially when compared to the Euro’s 20 percent rally against the British pound and New Zealand dollar and 27 percent decline against the Japanese Yen. However the mild year over year change in the EUR/USD masks a tremendous amount of volatility during the year. In the first half of 2008, the EUR/USD soared to a record high above 1.60. After that, it fell 22 percent to a 2 year low but recovered more than half of those losses in the month of December.

Eurozone’s to Underperform in 2009, Expect a Prolonged Recession

It is no secret that 2009 will be a tough year for many countries, but things will be particularly difficult in the Eurozone. Every major central bank has cut interest aggressively, driving their currencies significantly lower in 2008. The ECB on the other hand has been reluctant to follow suit, leaving the Euro only marginally lower for the year. Although the Eurozone is in a recession, growth has not been nearly as weak as the US. Annualized GDP growth in the Eurozone during the third quarter was +0.6 percent, compared to -0.5 percent in the US. The Eurozone’s outperformance in 2008 however could be short-lived as the central bank forecasts a 1 percent contraction in growth next year. As an export dependent region, the strength of the Euro will make a recovery difficult. German companies have already scaled back production as global demand eases. Looking ahead, unemployment is expected to rise, slowing consumer spending and forcing the ECB to continue to cut interest rates. If German unemployment hits 9 percent, we could easily see Eurozone rates hit 1 percent.

ECB Could Become One of the Most Aggressive Central Banks in 2009

Next to the Bank of Japan, the ECB has been the least aggressive central bank in 2008, having cut interest rates by only 150bp to 2.5 percent (counting the 25bp rate hike, their total easing is 175bp YTD). Compared to the 400bp rate cut from the Federal Reserve and the 350bp rate cut from the Bank of England, the ECB’s nimble move singlehandedly prevented the Euro from collapsing alongside the British pound, New Zealand and Australian dollars. However in face of slowing growth, it will be difficult for the ECB to hold onto their conservative monetary policy stance – they are expected to cut interest rates by 100bp in 2009. The ECB was behind the curve in 2008 and the biggest risk for the Euro in 2009 is whether the central bank’s sluggish policies catch up to them. In December, the EUR/USD soared on speculation that the ECB may refrain from cutting interest rates in January. At a time when everyone who still has room to cut interest rates are cutting them, a pause by the ECB could spur a EUR/USD rally above 1.45. However, with that in mind the ECB first hinted about pausing when the EUR/USD was trading at 1.25. The 13 percent rally in the currency pair since then increases the chance of a rate cut because a stronger currency hurts the economy. But a pause does not mean an end to the easing cycle. Beyond January, we still believe that significantly slower growth will force the ECB to cut interest rates by another 100bp. More importantly, the ECB will be cutting interest rates at a time when the Federal Reserve and the Bank of England are done easing. If the Eurozone underperforms the US economy in the second half of the year and the ECB is still cutting interest rates, a prolonged recession and prolonged easing could lead to a major reversal in the EUR/USD in 2009. Only if the economy proves to be resilient or if another major shock hits the US economy can we see a new high in the Euro.

Inflation Could Remain above ECB’s Target in 2009

One of the primary reasons why the ECB has been reluctant to ease rates aggressively in 2008 is inflation. The central bank has a 2 percent inflation target and consumer prices remained above the target throughout the year. In fact, the ECB became so alarmed in July when annualized CPI soared to a high of 4 percent that they raised interest rates by 25bp. Although the fall in oil prices has driven inflation lower by the largest amount in 20 years, CPI is still expected to remain above the ECB’s target in 2009.

Be Careful of a Run on the Dollar

Another major risk next year is a run on the US dollar. The global slowdown has forced many central banks around the world to become internally focused. This means that any excess money will be spent on spurring growth domestically instead of funding the US deficit. With next to zero yield, a deteriorating balance sheet and the risk of a weaker dollar eroding the notional value of any US investments, there are almost no reasons for foreign investors to load up on US debt. Having been burned badly by investments in Fannie and Freddie Mac, sovereign wealth funds like China have become skeptical of buying more US paper. According to an editorial in the state owned newspaper, China Daily, "China's increased purchase of U.S. Treasury securities should not be interpreted as an endorsement of the assumption that the U.S. can borrow its way out of the current financial crisis." If dollar demand continues to wane, it is another factor that could drive the dollar lower in the first half of 2009.

Political Risk

There will be 2 elections in Europe in next year– the election for the new Chancellor of Germany and elections for European Parliament. In Germany, Chancellor Angela Merkel is expected to take on her foreign minister Frank Walter Steinmeier. With an economy in turmoil, it is difficult to tell who will win but if it is another close election like one in 2005, we could see the Euro come under selling pressure. When both Merkel and Schroeder declared a victory in September 2005, the EUR/USD plunged as political uncertainty hit the currency. The European Parliament elections in June will be the largest transnational democratic election in history with over 700 members set to be voted in by 515 million EU citizens. For the currency market, the only implication is the possibility of legislative activity coming to a standstill in the spring as the European Parliament prepares for the election.

Technical Outlook for the EUR/USD

It is probably not a coincidence that the rally in the EUR/USD in December stopped right at the 50-week Simple Moving Average, which is hovering above the 61.8 percent Fibonacci retracement of the 1.60 to 1.23 bear wave. According to our Bollinger Bands, the EUR/USD is now within the Range Trading Zone. As long as it holds above 1.3760, the 38.2% Fibonacci support level, we could see a rally back towards 1.42. However, a break of 1.4685 is needed for the currency pair to have any chance of retesting its record highs. On the downside, a break of 1.30 would resurrect the downtrend.



British Pound 2009 Forecast

How Did the British Pound Trade in 2008?

The British pound was one of the worst performing currencies in 2008. It fell to a 6 year low against the US dollar and record low against the Euro in addition to selling off against every other G10 currency. The overwhelming weakness in the currency is a direct reflection of the impact that the credit crisis had on the UK economy. In the month of December, many currencies recovered against the US dollar, but unfortunately the British pound was not one of them. Although the pound could continue to weaken in the first quarter, the government’s aggressive fiscal and monetary stimulus should help the country recover towards the end of 2009.

Official Recession in 2009

Without two consecutive quarters of negative GDP growth, the UK economy is not technically in a recession but that should change in the first quarter of 2009, when the 2008 Q4 GDP numbers are released. Growth has been slowing materially and the weakness is reflected in the British pound. GDP growth fell by 0.6 percent in the third quarter, the largest decline in 18 years. The housing market and the financial sector have been the engine of growth in UK for the past few years and both blew up in 2008. Unfortunately the worst is probably not over for the 2 key components of the UK economy, particularly following the Bernie Madoff’s Ponzi scheme. In addition to losses suffered from the subprime mortgage crisis, many large hedge funds and European banks invested with Madoff’s. In 2009, they will be forced to write down those losses and deal with what could be pretty severe consequences for the financial sector as a whole. With the financial and housing market sectors expected to remain weak in the first half of 2009 and layoffs predicted to rise, GDP growth could fall as much as 2 percent next year. Although we believe that the country could be one of the first to recovery from the global economic downturn, this will not before more pain is felt in the UK economy. The severity of the UK recession will be largely dependent upon how quickly the credit markets are restored in 2009.

Inflation to Fall Back to 2%

Even though falling oil prices has driven inflation lower in the UK, the annualized pace of consumer price growth is still well above the central bank’s 2 percent target and even higher than their 3 percent upper limit. The latest data is for the month of October and according to that report, consumer prices rose 4.1 percent yoy. Despite the high level of inflation, the central bank has pretty much abandoned the inflation target and shifted their focus back to growth because they believe that the slowdown in the economy will naturally drive inflation lower. They believe inflation could fall back to 2 percent as early as the first quarter.

More Rate Cuts in First Half of 2009

Next to the Federal Reserve, the Bank of England has been the most aggressive central bank in 2008, having cut interest rates by 350bp to 2 percent, the lowest level in 57 years. Despite the massive interest rate cuts, tax cuts and other fiscal stimulus, the Bank of England remains committed to doing all that it takes to prevent a recession from sparking deflation. Central Bank Governor King believes that the economy will contract in 2009 and given his pledge UK interest rates could fall by another 100bp in the first half of the year. Although zero interest rates are not expected in the UK, interest rates will fall below 2 percent and until the Bank of England is done easing, the British pound may remain weak.

EUR/GBP at Parity

The sell-off of the British pound in the first few months of the year could drive EUR/GBP to parity. If that happens, it would be the first time ever that one Euro would be worth more than one British pound. This could not come at a better time than 2009, when the Euro celebrates its 10-year anniversary. In this past decade, the currency has risen from ashes to become more valuable than the 2 primary reserve currencies in the world. Although many Britons may be alarmed at the weakness of their exchange rate, the Bank of England will probably not step in to stop it from falling. Instead, the BoE will revel in the stimulative effects of a weak currency. There are already reports of Europeans from the Eurozone flocking to the UK for their holidays. The weakness of the British pound against both the US dollar and the Euro are key ingredients for an economic recovery.

Keep an Eye Out for a Recovery

Although the UK economy still faces many risks in 2009, there is hope. Consumer spending has been pretty resilient with November retail sales rising for the first time in 3 months. If the global economy begins to recover, we expect the UK economy to outperform its peers thanks to the Bank of England’s proactiveness. The currency has sold off significantly, providing additional stimulus for the battered economy. Even if there is no full-blown recovery, the UK economy is much further long in their slowdown than the Eurozone. Therefore if we see sharply weaker growth in the Eurozone economy in 2009, expectations for more aggressive ECB interest rate cuts may be all that the British pound needs to recover against the Euro. As for the US dollar, the recovery could come sooner if the quantitative easing forces the greenback lower. When the UK economy begins to recover, so will its currency.

Technical Outlook for the GBP/USD

The British pound experienced a drastic sell-off throughout the year as the price tumbled to a level not seen since 2002. The pair lost roughly 5000 pips as the BOE reduced the interest rates far more aggressively than other central banks. Currently, the pair is well below the 200-week and 50-week SMA reflecting in the change of the trend from an upward to a downward bias. Nevertheless, the pair seems to be oversold for the time being, needing a major retracement if it will continue to depreciate further. The pair still remains in the sell zone that is established using the Bollinger Bands, and until the price closes above the 1st Standard Deviation we could experience a further downtrend. Although the pair is destined to retrace at some point during the following year, the price still remains within reach of breaking further establishing a prolonged downward trend. Near term resistance is at 1.5723, the December high. The currency pair could hold above 1.45, but if it breaks that level, the next meaningful support is not until 1.40, which served support from 2000 to 2001.



Japanese Yen 2009 Forecast

How Did the Japanese Yen Trade in 2008?

The global economic turmoil and the subsequent unwinding of carry trades made the Japanese Yen, the best performing currency of 2008. The Yen rose more than 35 percent against the British pound, Australian and New Zealand dollars and hit a 13-year high against the US dollar. Unlike some of the other currencies, which may have seen wild swings throughout 2008, the Yen consistently strength throughout the year. Unfortunately the remarkable rally in the Yen will also be a big reason why Japan could underperform, its peers next year.

Japan Could be the Worst Performing Country in 2009

Of all the countries in the developed world, Japan will probably have the toughest time in 2009 because of the strength of its currency. As an export dependent nation, Japan typically runs a trade surplus but this year we have seen the country report trade deficits, which is extremely rare. Toyota, the world’s largest carmaker is the highest profile casualty of Yen strength. The automaker reported their first lost in 70 years as sales plummeted and the Yen soared. The toxic combination of a weak economy and a 16 percent rise in the yen against the US dollar has been disastrous for the automaker. Although Toyota is probably the most high profile, they are certainly not the only major Japanese corporation to be hit by the double whammy of a slowing global economy and a strong currency. Business sentiment across the country has already fallen to a 7 year low as exports decline by a record amount. Unless the Yen’s strength is suddenly reversed, we expect Japanese corporations to report more losses in the months to come. As of the third quarter of 2008, Japan is in a recession with growth shrinking by an annualized pace of 1.8 percent. Next year, GDP growth is expected to fall by 2.5 to 4 percent as weak domestic and international demand hits the economy. However it is important for currency traders to realize that the Japanese Yen does not always trade off economic fundamentals. The outlook for Japan has been bleak for months now, yet the currency is rallying because risk appetite has been the dominant driver of the currency’s price action. If the market is very nervous about the global economy, the Yen could still rise even if Japan’s economy continues to deteriorate.

Inflation: Consumer Prices Could Turn Negative in 2009

Like the rest of the world, inflation is slowing in Japan, but consumer prices still remain in positive territory. Nationwide, the latest data we have is from the month of November. During that month, annualized CPI growth slowed from 1.7 to 1.0 percent. However the combination of a strong currency and the continual decline in commodity prices could drive consumer prices into negative territory next year. A strong currency moderates inflationary pressures while a weak currency boosts it.

No More Room to Cut Interest Rates

With interest rates already at 0.5 percent in January 2008, we were surprised to see two obscurely sized rate cuts by the Bank of Japan that took interest rates down to 0.1 percent, within a whisker of zero. Although the BoJ Governor denies it, the rate cuts combined with plans to buy commercial paper and increase purchases of government debt essentially returns the country to quantitative easing. The only reason why the BoJ did not take interest rates to zero is because they do not want kill the repo market or give the public the perception that they have run out of ammunition. Looking ahead, we have probably seen the last of BoJ rate cuts and the central bank will need to rely on fiscal policy and a further expansion of the balance sheet to stabilize the economy.

Will Carry Trades Recover?

Between 2001 and 2006, one of the most lucrative strategies in the currency market was carry trades. However anyone long carry in 2008 was burned badly - GBP/JPY for example fell 41 percent to a 13 year low while NZD/JPY fell 39 percent to a 7 year low. Record volatility, massive deleveraging and global interest rate cuts created a toxic combination for carry trades. In order for carry trades to recover, central banks need to stop cutting interest rates, volatility needs to decline significantly and the global economy needs to recover enough for investors to be willing to start taking on risk. This could happen in 2009 but not until the second half of the year at the earliest.

Risk of BoJ Intervention

In the face of a deepening recession, a strong currency and little room to move on interest rates, everyone is wondering whether the Bank of Japan will physically intervene to weaken its currency. The problem is that the only type of intervention that has ever really worked is coordinated intervention and the BoJ will have a very tough time convincing the Americans and Europeans to take any steps that would strengthen their currencies. Since the problem is not unique Japan and stems from the West, the Japanese needs to stand aside and allow the US and Eurozone governments to work on spurring their own growth. If they weaken their currency and strengthen the dollar for their own short-term relief, it could actually be counterproductive. However with that in mind, as the economy worsens and the central bank runs out of options, intervention risk will grow.

Technical Outlook for USD/JPY

As you can see from the weekly chart of USD/JPY, the sell-off in the currency pair has been severe. Currently, the price is well below the 200-week and 50-week SMA and at the level not experienced since 1995. This puts USD/JPY in the Bollinger Band sell zone and even though a retracement could imminent, it could be an opportunity to sell rallies than buy on dips. The closest level of support is at the 161.8% Fibonacci extension of a low established in late 2007 and the high for the 2008 at 86.50. Resistance is at 94, the 10-week SMA.



Kathy Lien is Director of Currency Research at GFT, and runs KathyLien.com.