Forex Investment and Currency Trading

• The USD is likely to stabilize during the month ahead but struggle to post solid gains until 4Q 2008.
• There are more signs that EUR strength is increasingly at risk while the GBP has not benefited from expectations of BoE tightening as the UK economy weakens.
• The JPY appears to have lost its relationship with risk aversion as interest rate spreads come to dominate and weaken the JPY.

It was a rather eclectic first half of 2008 in global currency markets. The common theme was clearly USD weakness, although the common theme seems to end there. While EUR/USD and its rise to a “record” high dominated the headlines, EUR performance was far from top of the leaderboard. Instead, leadership came from higher-yielding commodity currencies (BRL and AUD) and the low-yielding, risk-averse CHF. Despite a previous positive correlation with the BRL and AUD, the ZAR performed extremely poorly among traded currencies. And despite increasing pressure on China to allow the CNY to rise more quickly, the CNY gain (+6.5%) closely followed the EUR (+8.0%).

If anything, the outlook for the remainder of the year looks even more uncertain. In fact, leadership among major currencies appears to resemble a version of the children’s game “hot potato”, in which the object is to pass the hot potato to another player as quickly as possible.

Market continues to believe that it is early for the USD to take leadership in currency markets. It appeared that expectations for Fed tightening were excessive, having risen too sharply from the mid-March lows. Since last month the expected Fed funds rate for mid-2009 has fallen by about 80bp. With eroding interest rate support and weak long-term capital markets, there is little reason for either short-term or long-term capital inflow into USD-denominated assets. And given continuing large external financing needs (current account deficit) there is little reason to expect to USD to regain a leadership role among developed currencies during the months immediately ahead.

Indeed, cyclical developments in the US economy appear to be weakening. While consumption activity remains relative solid, buoyed by tax rebates that will extend into August, the underlying conditions in labor markets suggest renewed consumption weakness in the final months of the year. The 20+ year low in optimism among small businesses (which create about 75% of new jobs), the ongoing increase in continuing claims for unemployment insurance, the cycle low in the growth of withheld taxes (1.0% YOY gain using 13-week MA) and the rise in the percent of households reporting “jobs hard to get” are consistent with a weakening of employment that should restrain consumer sentiment and spending during the last 1/3rd of the year into 2009.