In forex, the key event of 2006 was the Federal Open Market Committee (FOMC) ending the series of interest rate increases that started on June 30, 2004. Throughout the year, the anticipation that interest rate increases would end occupied a great deal of trader’s attention.
Forex traders are looking ahead to 2007 to see what currency pairs deserve our attention and which forex trading strategies may work. There are fundamental clues coming from Asia where GDP growth is the fastest in the world and has become the fundamental pivot point of the world economy.
In Japan the key event of 2006 was the increase in interest rates from 0% to 0.25%. This indicated a Japanese economic recovery was underway. However, the first increase in years was accompanied by a great deal of uncertainty. In its most recent (October) economic outlook, the Bank of Japan (BOJ) forecasted 2.1% real growth for 2007 with contained inflation. It stated, “The Bank will adjust the level of interest rates gradually in the light of developments in economic activity and prices while maintaining the accommodative financial conditions ensuing from very low interest rates for some time.”
The BOJ is being cautious. Economic progress in Japan can be disrupted with news of a less than robust recovery. Just after the positive October outlook report, the economic data release on Japanese domestic auto sales showed a 16th consecutive month of declining sales. Only 30% of economists in Japan predict a rate increase before the end of December.
With uncertainty on the timing of another rate increase, the implication for trading the USD/JPY pair is to align with the fundamentals for a stronger yen. Traders should welcome a weakening in the USD/JPY pair as an opportunity to sell this pair in 2007. This does not mean you should chase the yen as it moves downward.
Where does the yen stand against other currencies? If and when the BOJ raises rates again, it may begin the end of the carry trade advantage that has propelled the GBP/JPY into multi-year highs. The carry trade interest rate advantage has generated between $68 billion and $120 billion that would begin to reverse, causing a major increase in volatility and strengthening of the yen.
Forex traders should take a look at the Australian dollar in their research. The Australian economy is in its 15th year of expansion and at a 6.25% annualized growth rate it has benefited from the demand for energy and commodities from China and East Asia. The Australian experience of robust growth has generated associated labor shortages and high inflation of 3.9%. The Reserve Bank of Australia has raised rates three times this year and is expected to raise rates again. We may be seeing a topping of fundamental strength in the Australian dollar. Because Australia is an energy and commodity export based economy, if the commodity complex sells off and there is a global slowdown, the Australian trade would weaken and as a result the currency will likely weaken. In fact the first sign of a slowdown has occurred as the latest data shows that Australian employment unexpectedly dropped for the first month in nine in October. Technically, as 2007 begins the AUD/USD has been in a three-year sideways range from a monthly perspective. The coming year may well be when this sideways range breaks.
There are three wild cards to consider in writing the 2007 forex playbook. The first is geopolitical events. An aggravation of the North Korean crises will add volatility to the yen. A confrontation with Iran on its nuclear ambitions can cause oil to spike and generate unexpected inflationary pressure. The second wildcard is U.S. interest rates. If 2007 is the year that interest rates are cut, dollar selling in almost any currency pair will be the preferred strategy. But there still is potential for a rate increase if the personal consumption expenditure rate remains too high for the FOMC. Any positive news in U.S. growth prospects, which most recently slowed to a 1.6%, will cause a surge in the dollar. The final wildcard is Chinese growth and its currency management. China’s 10.4% annualized gross domestic product may prove difficult to cool off despite increased state macro controls and higher interest rates. Sustained growth and a stronger yuan means China can buy more Japanese and Australian exports.
A year ahead is a long period for any projections, but for forex traders 2007 has already begun to take shape.
Abe Cofnas is president of learn4x.com LLC and author of Understanding Forex: Trading to Win. E-mail: firstname.lastname@example.org.