2008 FX Outlook

While 2007 has been a rather interesting year, I suspect that 2008 will prove to be just as interesting while providing ample opportunities to those inclined to position accordingly.

In the pages that follow, I will outline some broad themes both in FX as well as other markets, that should help illuminate where I see the best opportunities in 2008.

Clients will of course enjoy continuous updates each day/week as these themes begin to play out and action is required. If you enjoy this 2008 Outlook, consider subscribing to one of our research services for continuous updates in 2008.

Highlights:

• The U.S. dollar should strengthen in the early part of 2008
• The yen will remain flat to weak versus both USD and other G10 currencies
• Global equity markets are caught between a credit crisis and a Fed which is thus far slow to react
• Reflation (i.e. Fed policies) will ultimately keep equity markets on firm footing
• Sector rotation will be key for equity performance
• Volatility will remain high across all asset classes
• Commodity currencies will diverge

The Fed: 'Stuck in the middle with you'

The Fed's current message of wanting to achieve 'modest growth' puts investors at a loss as to where the Fed's focus really is. I can only assume that the overriding fear of inflation is what is keeping the Fed from not being more aggressive in its stance to the current credit crisis. As is always the case, the situation has evolved to become a much bigger problem than many had first envisioned. Various spreads have blown out to new highs and the risk of further damage to credit markets is a real possibility. This scenario is quite deflationary and should alleviate the inflation concerns.

In all fairness, there are two sides to the story here. One is the current financial stress and the overall economic outlook. The later has thus far been relatively unaffected by the credit crisis, but the former, if not dealt with, could ultimately impact broad economic growth. For now, the Fed is being quite passive despite the rate cuts and other emergency measures, I suspect however that the Fed will ultimately lower rates at a much more rapid pace thus ending the stalemate we currently see in the financial markets. For now, the 2/10 Year Spread has widened considerably against the 10-year/Fed Funds Target Spread implying that the Fed is already behind by 70-80 basis points - a wide spread indeed.

Euro: 1.5000? Not Anytime Soon

The relentless rise of the euro combined with a softening U.S. economy should begin to take its' toll on the euro economy in 2008.

With business confidence tanking, the regional trade balance deteriorating and consumer spending having slowed to a crawl, the ECB will have to consider adopting policy easing to compensate for the impact that a strong euro has had in recent months. One problem however is that the ECB tends to be very hawkish on inflation and may not be ready to provide the monetary offset to the strong euro. This would be consistent however with the ECB always lagging behind the Fed's reflationary efforts. The result will be continued economic deterioration and lower inflation - this scenario all but ensures that EUR/USD will track lower during 2008.

Yen: Weak Yen Needed To Aid Ailing Economy

While the move lower in USD/JPY created a lot of chatter in the 4th quarter of 2007 that USD/JPY was destined for sub-100.00, this has not, and will not likely happen in 2008.

With GDP contracting, an aging population and slowing global growth, the BoJ is not likely to raise interest rates as the outlook for 2008 suggests further sub-par growth. The Japanese economy will continue to rely upon external demand, a delicate situation to be sure given the overall global growth situation. This scenario makes relying upon a cheap currency even more critical.

The historically inverse relationship between the U.S. yield curve and USD/JPY will need to be watched. The current flattening of the yield curve will keep upward pressure on USD/JPY.

Commodity Currencies: AUD and CAD Diverge

It can be argued that the surge in commodity prices may begin to level out in 2008 as global growth begins to slow. However the CRB chart shows no signs of exhaustion currently, but does have to overcome the May 2006 highs (365.84) in order for prices to sustain the push higher.

Absent a sharp decline in the CRB, the question facing both AUD and CAD is one of relativity. Given that AUD is more closely correlated to the economies of Asia (robust growth) versus CAD, which is more correlated to the U.S. (slower growth), I expect to see rates in Canada move lower, while rates in Australia will hold firm. This will widen the rate differential between these two currencies thus providing a backdrop from which I expect AUD/CAD to move higher.

General Forecasts (specific timing and entries/exits will be published to clients during the year)

Dollar Index (DXC) - bottoming process began in late November 2007 and while my near-term forecast s for higher prices, I fully expect prices to experience some set-backs that cast doubt on the rally.

EUR/USD - tying in with my DXC forecast, lower levels are in the cards. Near-term targets are seen at 1.4290-1.4030

EUR/GBP - while both EUR & GBP should be weak relative to the dollar in 2008, this one is a play on the least ugly of the two - in this beauty contest, EUR wins hands down. Expect EUR/GBP to be a steady push higher.

EUR/SEK - I expect Sweden to provide a far more favorable backdrop than will the Euro-zone in 2008. One look at the charts of EUR/SEK suggests further upside is likely.

S&P 500 - technically a case can be made for higher levels. This in addition to a Fed that will likely adopt a more reflationary policy will underpin the market and drive it higher.

VIX Index - the early part of 2008 will likely see continued volatility as the stalemate between the market and the Fed continues. Holding the VIX Index is one way to hedge/capitalize on the expected volatility.

Dave Floyd
Aspen Trading Group

Dave Floyd is a professional FX and stock trader based in Bend, OR and the President of Aspen Trading Group. Dave's approach to FX combines technical and fundamental analysis that results in trades that fall into the swing trading time frame of several hours to several days. For a free trial to Dave Floyd's Daily Forex Alerts click here.