This has been a really interesting year in the world currency markets. The news-worthy items, as with all things FX, are all interlinked in complex ways.
This year the dominant factors in the world of international business and finance have been international interest rates; the price of commodities and the slide of the US Dollar; the Yen carry trade and subsequent credit crunch; US housing woes and the sub-prime collapse -
ALL the big finance stories of 2007 - and it has been a mega year for finance news - all the stories, every single cause and effect, is rooted in FX movements.
It is not possible to tell the story of this year's currency markets highlights without also mentioning XAU. Gold - as a precious metal - is traded the same as a currency on the spot markets and this year has been a never-ending series of developments. It's importance on the spot market will continue to grow as the emerging markets develop.
This is a summary of the important trends and how the various components unfolded and developed over the course of the year.
In January Gold had been slowly maturing for years, but 2007 will probably be the year that is remembered as the year of the Gold baton-change. The nation that controls the value of XAU changed from the USA to India. In January 07 US investors were beginning to get bearish on XAU and bullish on the USD. Normally that would be enough to make the Dollar raise and the price of gold fall, but despite the start-of-the-year run on commodity prices, XAU held up surprisingly well.
This was because the rest of the world, particularly India, was buying gold. And lots of it.
The Yen came under pressure as it became unlikely that the Bank of Japan would increase the very low interest rates even though the rest of the world's central banks were increasing theirs. During this time the JPY carry trade was alive and well and money was flowing quite freely around the money markets although the phrase "sub prime" was, by this stage, widely recognised as likely to cause a future problem, it was one that had not yet landed.
The US Dollar had done well against the JPY and the Euro (hitting a 13 month peak against the Yen)
Towards the end of January the UK Pound Sterling (GBP) hit a 14 year high against the US Dollar as the surprise UK rate hike earlier in the month made buying GBP popular. Gold also continued it's climb against almost all currencies.
An interesting numerical coincidence saw the HK dollar (HKD) and Chinese Yuan (CNY) reach parity for the first time. In years to come these two Asian currencies will probably be tied together, but at the moment they are allowed to float independently of each other.
With the booming Chinese economy and strong exports, the Yuan is appreciating, as it must naturally, but comments that have been made by US politicians indicate that they do not believe the CNY is appreciating fast enough against the USD - at least not fast enough to be good for the USA. Eventually someone in Washington will figure out the other side to that FX equation: a falling Dollar will have a pretty similar effect to a rising Yuan. But let's not get ahead of ourselves.
February saw further calls form Paulson and other US senators to tackle the problem of the undervalued CNY, which they claim needs a correction of about 40% versus the USD.
Gold continued it's push upwards against the world's currencies, and of course XAU/ USD. After breaking through the resistance levels at about $650 many in-the-know were predicting a straight run to $700 as Gold continued to rise in value while its currency of valuation, the USD, continued to slide.
By mid February JPY had rallied slightly after data showed that the Japanese economy had expanded faster than expected in Q4. This raised the prospect of Bank of Japan interest rates rises, which was the cause of the small rally in the Yen.
But the overall picture for JPY was not great. EUR/ JPY was not doing so well after the G7 summit. On the 12th of February the Yen hit record lows against the Euro.
In America, monthly capital inflows reversed to outflows of approx $11Bn, the first since mid 2005. The outflow of currency and disappointing industrial data caused the USD to recede again, with all the main currencies: JPY, EUR, and GBP all taking bites out of the USD's rate.
This early in the year, US treasury secretary Henry Paulson was still saying that a strong dollar was "in the interests of the USA" and the St. Louis Fed. President William Poole was saying that US inflation above 2% would be “unacceptable”, while San Francisco Fed Chairman Janet Yellen was saying that US inflation was already “too high”.
It was in March that the USD (arguably) started what was to turn out to be a long drop, when the US started to add tariffs to Chinese imports into the USA.
The USD also started to lose some ground against the JPY. A series of factors meant that investors started to reduce holdings in riskier assets, financed by the Japanese carry trade, which is money borrowed in JPY, converted to a new currency (typically one with high bank interest rates, such as the NZD, AUD, BRL, or ISK) and then held on deposit in the new currency.
These important developments were a small taste of things to come.
Increased Mid-East tensions, now also incorporating Iran, did not help the negative sentiment against the USD, and the capture by Iran of British naval personnel (subsequently released) did little to help matters.
However, the US interest rate outlook was still given broadly as a "hold" for the foreseeable future - one thing that was stopping the dollar from really sliding.
UK retail sales grew by the strongest rate in more than a year and with the highest interest rates of any G7 country, with the prospect that they could rise further to help cool inflation, the GBP consolidated its position against the other major currencies.
The Brazilian Real (BRL) and the SA Rand (ZAR) were two of the biggest spot movers rising 3.72% and falling 3.67% respectively in the month of March vs the USD.
April was 2007's first big month of big records. The GBP had leapt to a 15 year high against the USD by the middle of the month. Major commodities like oil, steel and non-industrial commodities like gold, all being both in high demand and denominated in USD, meant that the spectre of inflation had manifested itself in the UK. The UK economy had been enjoying a slow-release boom for almost a decade, but now interest rates would have to rise to keep things in check (not least the UK housing market which had been too hot for a long time).
The prospect of UK rates rising made the GBP an even more desirable currency for FX buying and it pushed USD/ GBP back over the $2 mark. The pound ended up surpassing the JPY as the 3rd most popular reserve currency for Central Banks, behind only the USD and the EUR.
XAU - Gold hit its first landmark of 2007 on April 6th when it surpassed the $600 level. Gold had been in high demand already but uncertainty about future US interest rate decisions and the US economy as a whole led to higher XAU prices. It is everyone's favourite inflation and USD-depreciation hedge.
By April 19th gold had hit its highest price (on a nominal basis) in 25 years. Gold for immediate delivery stood at $624.80 - the highest price since December 1980 - and XAU was similarly buoyed.
Higher commodities prices were again cited, as traders thought that inflation would be hit by higher costs filtering through the system.
As the USD continued its slow fall the JPY started to appreciate broadly as investors continued to unwind the JPY carry trade. The JPY rebounded from a record low against the EUR in mid April and continued to climb against the USD. Rumours that the Bank of Japan may start to report higher consumer prices, and therefore have to raise interest rates, was making people that had borrowed JPY to invest in higher yielding currencies think about closing their positions.
By the end of May the majority of FX traders had figured out that if the USA pursued a weaker currency it would create a mini economic boom within America; make repayment of debt to other nations easier and help alleviate some of the pressure from the Sub-Prime crisis.
US consumer confidence was also at its worst since hurricane Katrina, but European confidence hit an unexpected 6 year high. Inflation in the Euro zone seemed to be under control at less than 2% for the first time since 1999 when the Euro began operation.
Future expected interest rate rises by the European Central Bank (ECB), due to the increasing prices of commodities and raw materials, mean that the EUR continues to firm, especially against the USD. Euro companies voice concern on the impact of a rising EUR on exports.
In June, a rash of Arab nations ended their USD peg of their local currencies. A combination of political and economic factors were cited but the main reason was probably the persistent fall of the USD's value against other currencies.
By this time the JPY carry trade has become so mainstream that Japanese politicians are openly commenting on the potential risks to some investors. However with the crucial JPY/USD rate in the low 120s, currency strategists were still reticent about the prospects of a full unwinding and hardcore strengthening of the Yen.
Some traders may have been coming to similar conclusions to the Japanese politicians, as the USD and SRF start to become the currency of choice for many carry trades.
The USD had rallied since it's lows of April against the GBP and EUR and managed to hit a 4 year high against the JPY
Central banks allowed their reserves of the US Dollar (in percentage terms) to fall to the lowest level in about 8 years, switching to Euro instead, meaning that USD/ EUR was rising.
The ECB raised rates, as expected, which made the EUR even more attractive to buyers and a hot FX favourite.
News that SA miners were going to strike did little to quell the rise in XAU, and XPT (platinum) follows suit. Gold had its biggest weekly gain since July 2006 as the USD fell.
Russia allowed the rouble to appreciate by 0.5% for the 2nd time this year due to pressure from strong commodity prices and a large inflow of capital from other countries.
Arab states, such as Kuwait, that had not abandoned the USD peg were forced to revalue in July - twice in Kuwait's case. The problems may effectively have ended plans for six gulf states (including Saudi Arabia) to undertake a new free-floating common currency by 2010.
Inflationary pressures due to the USD peg was the catalyst that caused the problem.
The USD itself reverted to falling against the major currencies in July, hitting fresh record-lows against the EUR and another 26 year low against the GBP over concerns that the sub prime mess will damage the US economy. The steady and predictable falls in the USD meant happy days for most FX traders.
A global hit to the stock markets made several carry traders decide that the risk was no longer worth it and the JPY carry trade began to unwind in earnest. In effect this meant that a lot of people started buying JPY all at once, which meant that the JPY appreciated quite well across the board.
But borrowing in Yen had underpinned the world credit markets. Private equity firms were suddenly unable to source the billions they needed for their buy-out plans and the seeds of the global credit crunch were well and truly sown. This would effect currency exchange for the rest of the year (and potentially for much longer).
During the first week in August more credit market worries sent the Dow tumbling by 400 points and the odds of at least one US interest rate-cut rose dramatically.
Despite this, the USD clawed back some ground against most currencies during the first 10 days in August. Particularly emerging markets currencies. The Brazilian real (BRL) and Icelandic Krona (ISK), two popular destination currencies for the carry trade, lost 1.2% and 2.7% respectively.
Even more of the Yen carry trade started to unwind as investors and traders became more and more risk-averse. So many people buying JPY at one time helped maintain the Yen's lofty values.
It was about this time that the international credit market ran dry and Northern Rock found itself very much exposed.
Further falls in US house prices added to global uncertainty and fears. The Fed's response was to lodge a steep cut in the discount rate – a 0.5% drop.
XAU was already in nose-bleed-high territory, but now with the US cutting interest rates sparking fears of inflation, and international credit markets, Gold consolidated its positions at these highs. Future moves for XAU would most likely be up, even from here.
The USD/ EUR rate had recovered a bit from the record lows in July, but USD was put under pressure again by the Fed's move.
In the UK the economy's data was looking good. Gross Domestic Product was up, but under the surface the credit crunch had started to bite, causing uncertainty for the UK's future prospects and falling rates for GBP trades.
The GBP's 26 year record versus the USD had gone, and the USD had regained a full 3% in the month from the 24th July to the 24th Aug.
September saw the Northern Rock crisis in full swing as the Bank of England was forced to give the bank an emergency loan and depositors queued round the corner to withdraw money.
The USD fell to a fresh all-time low against the EUR as the Fed cut interest rates again. In the 3rd Quarter of 2007 the USD had posted a drop of more than 5% against the Euro - the biggest quarterly drop for more than a year.
For the first time since 1976, CAD (Canadian Dollar) was at parity with the USD.
The Fed's "Trade Weighted Index", which compares the USD to several major currencies, dropped on Sept the 25th to its lowest level since it started in 1971.
By this time in 2007 the USD has lost 7.5% against the EUR, 4.3% against the GBP and 3.6% versus the JPY.
But the Yen itself was having as bad a September as the USD's whole year, as it fell against all the major currencies (except the USD) - carry trade investors reversed course and started borrowing Yen again after the US interest rate cut. The AUD and NZD (carry trade favourites due to the significantly higher deposit-rates available in those countries) saw massive leaps. The AUD was up more than 7% and the NZD by approximately 6.5%. Against JPY/ EUR declined 3.7% to approximately 163 per Euro. This reversal had come on the back of steady climbs earlier in the year, and even within the quarter the Yen was still up against most currencies (except the Norwegian Kroner).
XAU leapt on the poor US sentiment and fresh interest rate cut, as a hedge against the USD. Gold went to its highest nominal level since 1980 breaching $735
October, and the records keep coming. The USD/ EUR rate hit another record since the new currency's inception and XPT hit a record high.
Gold for December delivery had risen to $768 by Oct 18th and most currency traders already knew that, chances were, the Fed would cut interest rates again due to the continuing credit crisis and the impact it could have on the US economy. The chances of the USD slide actually stopping for anything more than a breather were slim.
The GPB remained strong during October and started to firm against the USD again. By the end of the month the USD/ GBP was hitting $2.07 in intra-day trades - the highest value for about 30 years. This was in part due to a divergence of the interest rates between the UK and USA as American rates were falling while UK rates were expected to remain high (or at least fall slower) based on the comments of Mervyn King, the chairman of the Bank of England.
The Bank of Japan left interest rates where they were as Japanese economic data did not show the levels of growth or inflation some analysts had forecast. Sentiment behind the JPY softened and although Yen spot rates did not plummet, many traders started to come back to the Yen carry trade, meaning that the forward rates for JPY were going to go lower, or at least – so it seemed at the time.
November saw yet more big moves for the USD with a decline of 4.7% against the JPY and 3.7% against the Swiss Franc (SFR) by the 19th of the month. And the rout wasn't over. Analysts are predicting the chances of further US interest rate cuts before the year end to be 80%, which would mean even further falls for the USD against most currencies. Projections for JPY/ USD rates are as low as 100.
The Gulf States, including Saudi, are again feeling the pressure of their ties to the dollar and revaluation may become a matter of necessity rather than a matter of choice.
There is even some talk of the price of oil and some other commodities being quoted in Euro to stop the dollar-led oil inflation caused by the sliding value of the USD.
More revelations about losses in US financial companies mean that the JPY posted some gains against the major world currencies and the Dollar - up to a 2 year high against the USD. More risk-aversion meant that people were less likely to borrow Yen, meaning JPY/ USD will remain high for a while yet.
It was a similar story for the SFR (Swiss Franc), with sentiment under-pinning the currency, and less borrowing for carry trades, the SFR will remain strong.
The GBP fell to its lowest level against the Euro since 2003 as the effects of higher interest rates started to slow growth in the UK economy and seriously impact GBP FX prices.
The Chinese Yuan (CNY) appreciated, with CNY/ USD at 7.4 for the first time since the Dollar peg was 'scrapped' in 2005.
The USD/ EUR had hit a new record lows by the 23rd of Nov. This means that so far this year the USD/ EUR has dropped more than 12%.
The issues that have been major influences on currency markets during 2007 will cast long shadows into 2008 and probably beyond even that. Potentially we are just witnessing the start of currency revolutions where the “mighty US dollar” becomes a thing of the past – or at least has less influence on the world markets – with new currencies, such as the Euro and further into the future the Yuan having a much bigger role. Over the next 12 months, however, regardless of whether it rises, falls or remains broadly stable, XAU will probably be taking up a large amount of the USD's slack.