The Underlying Fundamentals
Two holiday weekends in a row have given the Currency Markets a bit of a breather. This slowdown comes after months of exciting action and leaves the dollar trading significantly lower versus the Pound, Euro and Aussie. In contrast, the Yen has been unable to gain ground on the dollar and has reached new lows versus the Euro. As 2006 comes to an end, I thought it prudent to recap the most salient factors in the currency market from the past year. Here in the U.S., a precarious balance between a soft landing and a recession has kept the Federal Reserve and chairman Bernanke on their toes. Two years of successive rate hikes ended a few months ago and has been followed by two consecutive pauses. A quick look at the Fed Fund Futures implies market participants believe the stable rate environment will continue through the 2nd quarter of next year. Whether or not that forecast comes to fruition all depends on fluctuations of current inflationary pressures in the U.S economy. Recent weakness in the housing and energy markets have eased those concerns a bit, though a more dramatic decline in home prices and sales could predicate the threat of a real recession. Couple the unstable housing sector with a tight labor market and the scenario becomes a bit more complicated. Consider that the natural rate of unemployment is approximately 5%, and the current unemployment is closer to 4.5%. An economist would tell you that low unemployment is good for the economy but only to a point. Unemployment below 5% generates upward pressure on wages, the result of which is an increase in inflationary expectations. It is also important to watch for changes in labor force productivity; these can help offset a marginal increase in wages. Recently the U.S has seen a rise in productivity and this is definitely a good thing. However, to be of any real help the increases must continue. All things considered, and it is very clear why the Non-farm Payrolls has been such a market mover in 2006, and is likely to continue in that role in 2007.

A stark contrast to the uncertain U.S economic environment has been the strong and stable growth in the Euro Zone and Britain. The result of this strength has the Euro and Pound ending the year with double digits percentage gains against the dollar. I expect that trend to continue, at least until something fundamental changes. However, both the ECB and The Bank of England remain much more likely to raise rates than the U.S Fed, and the improving interest rate differential should continue to support their currencies. That being said, any excessive increase in Euro Zone inflation could reverse that trend, but for now inflationary expectations remain in check. Unfortunately, the situation surrounding Japan is not quite as clear. From my perspective the Yen is the biggest wildcard heading into next year. Earlier this year the Bank of Japan finally raised rates from 0%, the first sign of life for the Japanese economy in years. Unfortunately, it is not yet clear what effect an interest rate of 0.25% or perhaps even 0.5% will have on their fledgling recovery. Nonetheless, it is also imperative for Japan to stimulate the inflow of foreign capital to aid their recovery. In order to do so rates must increase, but until that happens expect the Yen to continue to lose ground against the Euro and tread water against the dollar. After all that fundamental jargon and before I sign off on 2006, I thought I should clarify my own philosophy a bit. As most of you know, many traders believe fundamentals are not really important to being a successful trader. However, I have found much more consistent results in my own trading by combining both disciplines. Using fundamentals to determine the long term trend and technicals for risk management, you get the best of both worlds. As a trader I am always looking to improve my edge.

GBP/USD
The cable is consolidating between support near 1.95 and resistance near 1.9715. Recent trading action within this range has been bullish and this is evident from two strong bounces off support. Use the established range to trade in and out of your positions, and watch for a major break to catch a big move. If you trade options look at straddling the pair at the current level.

EUR/USD
The Euro is also in a trading range with support near 1.31 and resistance at 1.32 & 1.33. I favor the long side of this pair as well, but will continue to trade the range until a breakout occurs. Buy a break above 1.32 with a trailing stop.

USD/JPY
The Yen finally pushed through 118.30 resistance and is becoming overextended as it approaches 119.50 & 120 resistance. Even though my short trade from 118.30 did not work, I still favor the short side of this pair and would sell a reversal top above 119.20.

USD/CHF
This pair continues to drift without any real conviction, and appears to be losing momentum as it nears 1.23. Overall the trend is still down and I would look to short a reversal above 1.23. A decline to 1.19 is not unrealistic if a reversal occurs.

AUD/USD
On Thursday the Aussie rallied strongly towards its highs near .79. I remain bullish on this pair and would add to my long position on a break out to new highs. On the downside strong support is at .78 & .7850 and I would buy dips with tight stops.

USD/CAD
The longer term uptrend in this pair has done quite well for us. In the short term I expect the resistance @ 1.17 to come into play, though I do expect this pair to continue up over the long haul. Keep stops tight to protect profits as the pair approaches closes in on 1.17, and use a consolidation to reenter once volatility settles down.

Derek Frey is Head Trader at Odom & Frey Futures & Options.

Risk Disclaimer 
Past performance is not indicative of future results. Trading futures and options is not suitable for everyone. There is a substantial risk of loss in trading futures and options.