US Dollars: Best Trade of 2007, What Is In Store for 2008?

Selling US dollars was one of the best trades of 2007. Since the beginning of the year, the dollar has fallen as much as 13 percent against the Euro, 10 percent against the Japanese Yen and 8.5 percent against the British pound. The story of the dollar’s weakness also captured headlines around the world. It became so pronounced that supermodel Gisele announced her preference for being paid in Euros over dollars.

Everyone from our barbers to our bartenders has been asking us when the US dollar will bottom and just when that happened – the dollar’s slide came to a screeching halt. The question now is will the turn in the dollar last or will the weakness resume in the New Year.

There are many factors at play. With high inflation still a problem, the Federal Reserve is running out of options. Over the past few months, Bernanke has needed to come up with more creative ways to calm the credit market. Their big liquidity injections have helped to bring down LIBOR rates, but uncertainty in the markets could also reverse their efforts in a blink of an eye. This is why they have pledged to conduct biweekly auctions of short-term funds for as long as necessary.
However subprime problems will not go away until banks have reported all of their off balance sheet losses.

When we stop hearing bad news and start hearing some good news, we will see the major shift in the markets that everyone has been hoping for. 2007 has also been about the decoupling story and we believe that recoupling will become the story of 2008. Many countries around the world have been lucky enough to skirt a major slowdown but if US growth continues to slow, the surprises next year could be from places like the Eurozone. Hawkish comments from the European Central Bank have encouraged traders to price a rate hike next year.

If growth slows, those expectations could shift from a rate hike to a rate cut, which in turn would be positive for the dollar and negative for the Euro. 2008 is also an Election Year. The financial markets tend to favor Republicans over Democrats, especially since taxes are expected to be increased under a new leadership.

Written by Kathy Lien, Currency Analyst

DailyFX

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