Is Dollar heading for a big fall?

In what could only be described as a move “from the frying pan to the fire”, one of the consequences of the European crisis has been the increased demand for the Greenback. We have witnessed the dollar index strengthening to 82-plus, with a corresponding decline in commodities like gold and oil. Most currencies also declined in this period—the Aussie and Canadian dollars declined from 1.1-plus levels to parity or less and we have had similar percentage declines with other currencies as well. To that extent, the decline in the exchange rates of the INR (Indian rupee) vis-à-vis the USD was not entirely based on fundamentals and we should witness a return to sub-50 levels over the course of this year.

Dollar down for second straight week

The dollar was headed for a second weekly decline versus the yen amid speculation that the Federal Reserve will take additional steps to shore up a sluggish US economy. The euro maintained a three-day gain versus the dollar, which fell to the lowest level since March versus the common currency. The US currency is down 1.2% against the yen and 1.6% versus the euro this week. Asian currencies were set for a fifth weekly advance versus the greenback, the longest winning streak since March, after data showed that China’s manufacturing activity improved. The dollar touched US$1.3764 against the euro, the weakest level since March 17. The US currency fell to 83.16 yen, the lowest level since Japan intervened in foreign-exchange markets on Sept. 15. The euro rose against the yen.

Yen slumps vs. dollar on government intervention

Japanese stocks spurted as the yen plunged against the US dollar on the first government intervention in the foreign currency market since March 2004 and pledged to do more if needed to preserve its export-led recovery. A stronger yen erodes the competitiveness of the exports that are the key driving force behind Japan's economy. The yen plunged to 85.78 per dollar from a 15-year high of 82.88. Exporters benefited from a weaker yen, sending the benchmark Nikkei 225 Stock Average up 6% during the week to 9,626.

Dollar falls to new 15-year low vs. yen

The US dollar fell to a fresh 15-year low against the Japanese yen as investors flocked to safe haven assets amid persistent worries that the global economic rebound could be losing steam. The dollar eased to the lower 83-yen level, and set a fresh 15-year low of ¥83.34 before recovering. Japan's finance minister Yoshihiko Noda said that the government stands ready to take steps against the rising yen, if necessary, and that the steps could include exchange market intervention. Separately, the Bank of Japan Governor Masaaki Shirakawa said today that the central bank is prepared to announce additional quantitative easing measures if economic conditions deteriorate.

Dollar - what's happening out there?

Dollar - what's happening out there?

US dollar: Destination known, road unknown

by Vivek Kaul, DNA

"The US dollar is not strong because people want to hold the dollar, but it's strong because people have debt in dollars."
--George Soros, renowned hedge fund manager

"You know, I have been here for almost a month now and still haven't figured out what I want to do," she said, late on a Sunday afternoon.

"When you don't know where you are going, the journey is the reward," I replied.

"So funny," she replied rather agitatedly.

"OK, let's go out somewhere," I said, grabbing her hand and leading her out of the house.

"What's on your mind? You know, you can be really weird at times," she said as we reached the bus stop.

"We'll take the first bus that comes here, wherever that goes," I said, sounding weirder.
One did five minutes later; a 33 to somewhere. We hopped on and bought two tickets to the last stop.

"Where does this bus go?" she asked.

"I don't know!" I replied.

"Is this some sort of a joke?"

"Like I said, when you don't know where you are going, the journey is the reward. So, enjoy it."

"Oh! I think I'll flip the point you are trying to make. Take the US dollar, for instance. From what we have been discussing, we know it will ultimately crash --- when and how, we don't know. Destination known; road unknown. You know where you are going, but not how and when you will get there. Is the journey still the reward?"

And I thought I had the penchant for linking anything to anything.

"Interesting," I said. "But I think I have some idea of how the US dollar will get there. For 2009, the projected fiscal deficit of the United States is $1.85 trillion. That's four times higher than the maximum deficit the US has previously run. This estimate has been made by the Congressional Budget Office (CBO). It also estimates that the deficit will be $1.4 trillion in 2010. Estimates made also suggest that between 2010 and 2019, the US will run a total deficit of $10 trillion. As you know, fiscal deficit is essentially the difference between what the government earns and what the government spends. And given that it plans to spend more than what it earns, the remaining money needs to be borrowed. Also, like most forecasts, this forecast is also a wee-bit optimistic, I feel."

"As in?"

"See every forecast is made using some assumptions. The CBO has assumed an unemployment rate of 8.8% for 2009. The rate has already touched 8.9% at the end of April. Also, from the way it looks, unemployment in the US is only going to increase in the days to come. Other than this, CBO assumes that the gross domestic product (GDP) growth in 2010 will be 3.8%. Now, given that the GDP contracted by 6.1% in the first quarter of 2009, hoping it will grow at 3.8% the very next year is pretty optimistic. My view is the US fiscal deficit will be more than what it is being projected. And all this money will have to be borrowed."

"Yeah, it will have to be borrowed. But with countries like China and Japan ready to lend to the US, where is the problem?"

"Hold on. In March, China and Japan were net buyers of $48.5 billion of financial securities issued by the US government. These financial securities pay a certain rate of interest and are issued to borrow money. Even Russia bought $8.3 billion of financial securities issued by the US government. Some experts have questioned the credibility of these figures, but assuming you and I trust these figures, there are some serious problems otherwise as well," I said, looking out the window, and realising how little traffic the city had on a Sunday afternoon.

"And what are these problems, if I may ask."

"Estimates suggest the US government needs to borrow $1 trillion by September. It will be very difficult to raise such humongous amount of money given that exports of the major buyers of these securities are falling. Chinese exports are down 41% and Japanese exports are down 38%. These countries earn US dollars through exporting goods and services.

These dollars, in turn, are used to buy securities issued by the US government. When exports fall, dollar earnings also fall. Given that, where will all the dollars to buy these securities come from? Also, we need to remember that the US is not the only country in the world that is running a fiscal deficit. Most of Europe is running a fiscal deficit, and so is Japan. And all these countries need to borrow. One estimate suggests the US, Japan and Europe need to borrow $5 trillion over the next two years. Now, let me be optimistic for a change and assume that there are enough buyers for these securities. But even with that, will the US government manage to find buyers for financial securities amounting to another $5 trillion, which it needs, over the next four years? This, given that the government will continue to spend more than it earns."

"Hmmm... I see even optimism can lead to pessimism. So what is the way out?" she asked as a spurt of wind blew her hair on to my face.

"I guess the only way out is to print money. The Federal Reserve of the US is currently authorised to print $1.75 trillion. This money will be used to buy back financial securities issued by the US government. The theory is that more money in the economy will lead to people spending people more and that in turn will revive the economy. Most western economies are resorting to this in order to get their economies up and running again. Bank of England is planning to buy back bonds worth 75 billion pounds. And the European Central Bank, the central bank of the European Union countries, also recently announced that it would start printing money."

"But wouldn't all this money printing be disastrous?"

"Over a period of time? Yes. But right now, the impact of this has been extremely benign. See, the idea was that increased money in the economy will make people spend more and that in turn will lead to people spending more. But right now, people are tired of spending and not in the mood to spend. That cannot continue forever, and as and when they do start spending again, too much money will chase too few goods and inflation will start showing its ugly head."

"I recently read an interview of Ben Bernanke, where he said, "When the economy begins to recover, that will be the time that we need to unwind those programmes, raise interest rates, reduce the money supply, and make sure that we have a recovery that does not involve inflation.""

"At the cost of repeating myself, economics is not an exact science and I am sure Bernanke also knows that, notwithstanding what he said in that interview. So assume prices start rising in the US and the US government along with the Federal Reserve to start reducing money supply. The simplest way to do it would be to start selling the financial securities they have been buying these days. Once they start doing that, they will be able to suck out money from the market, at least theoretically. But imagine what impact that would have. The biggest buyer of these financial securities would suddenly turn into the biggest seller. Given that, at that point of time, will there be enough buyers of these securities? The prices of these financial securities will crash, as there would be very few buyers at that point of time. Also, as inflation rises, investors who have bought these financial securities would want to sell out."

"Why would they want to sell out?"

"Inflation reduces the value of the money and given that expectation, investors would want to get out and spend that money. All this will lead to the price of these financial securities crashing. And that will also lead to the US dollar crashing because countries like China, Japan and Saudi Arabia own most of these financial securities. Once they have sold off these securities, they would want to convert the dollars they have got selling these securities into their own currencies. A spate of dollar sales is likely to hit the market, and that in turn will lead to the value of the dollar crashing against other currencies."

"And when will this happen? she asked.

"I wish I knew. But as renowned economist Nouriel Roubini, who predicted this crash, recently said, "This decline of the dollar might take more than a decade, but it could happen even sooner if we do not get our financial house in order. The United States must rein in spending and borrowing, and pursue growth that is not based on asset and credit bubbles. For the last two decades, America has been spending more than its income, increasing its foreign liabilities and amassing debts that have become unsustainable," I said.

There was a tap on my shoulder. "Last stop," the conductor said, asking us to get down.

"So where are we?" she asked.

"Goregaon," I said, looking around. "Now that we are here, let us find a coffee shop first."

(The example is hypothetical)

Re vs $ in 3 months

< 35 - 41 votes (8%)

> 35 < 40 - 358 Votes (72%)

> 40 < 45 - 87 Votes (17%)

>45 - 9 Votes (1%)

Total Number of Votes - 495


See Our Other Polls

Dollar Update

Dollar falls below Rs 40, 9 year high

Dollar falls , Fed move watched

The dollar slid to a 15-year low against a basket of currencies on Monday, 10 September, after data showing US employers cut jobs for the first time in four years, stoking expectations for a hefty Federal Reserve rate cut this month.

Friday’s data showing companies cut 4,000 jobs last month, the first such decline since August 2003, leading investors to see a bigger chance the Fed will cut rates by 50 basis points next week to protect the economy from the housing market crisis.

Investors again sold the dollar on Monday after the unexpected drop in US jobs.
“The trend in the dollar is clearly downward,” said Tsutomu Soma, a senior manager of foreign securities at Okasan Securities.

The dollar’s trade-weighted index against six major currencies fell to a low of 79.826, the lowest since September 1992. It later pared its losses and traded at 79.927.
The dollar fell to as low as 112.60 yen on electronic trading platform EBS early on Monday but trimmed its losses on buying by Japanese importers and stood at 113.31 yen down a tad from around 113.40 yen in late US trading on Friday.

A 2.2% fall in Japan’s Nikkei share average, following a decline on Wall Street, prompted investors to trim risky yen carry trades, pushing down the dollar and higher-yielding currencies against the yen.
But Japanese importers bought the dollar aggressively, helping limit its losses, traders said.

In yen carry trades, investors use the low-yielding yen to finance purchases of assets with higher returns elsewhere. That kind of trade played a big part in the yen’s fall to a trade-weighted and inflation-adjusted 22-year low in June
Analysts believe the Fed may opt for an unusually big cut in rates from the current 5.25% to help restore confidence among banks that have become reluctant to lend to each other, leading to strains in money and credit markets.
“A September Fed rate cut is a done deal,” said Hiroshi Yoshida, a forex trader at Shinkin Central Bank. “The market is now focused on whether it will be by 25 or 50 basis points.”
The Fed usually moves in 25 basis point increments, but worries about exposures and commitments of banks to US subprime mortgages, asset-backed commercial paper and structured investment vehicles has caused money market trading to dry up.
While the interbank lending problems have affected sterling and euro markets as well, investors are increasingly turning negative on the dollar as the US economy shows most evidence of taking a hit from the housing problems.
The euro edged up 0.09% to $1.3778 edging back towards a high of $1.3853 struck in July — the highest since the single currency was first launched in 1999.
It was little changed at 156.08 yen after falling to as low as 155.15 yen on EBS earlier on Monday.
The high-yielding Australian dollar fell 0.6% against the yen and the New Zealand dollar slipped around 0.4% versus the Japanese currency.
Japanese economy shrinks
Government data on Monday showed Japan’s economy shrank 0.3% in April-June from the previous quarter, against an initial estimate of 0.1% growth.
The gross domestic product data reinforced expectations the Bank of Japan is likely to leave interest rates unchanged at 0.5% at a 18-19 September policy meeting.
“If signs emerge that the global market turmoil has a negative effect on the real economy, the BOJ might be forced to put off a rate hike this year,” said Takeshi Minami, chief economist at Norinchukin Research Institute.
The market shrugged off the Japanese data, however, as investors were more worried about the health of the US economy, expecting the dollar’s yield advantage over the yen to shrink if the Fed cuts the benchmark interest rate.
The European Central Bank held interest rates at 4% last week, citing increased market uncertainty as the reason for its wait-and-see approach.

China threatens US dollar

The Chinese government has begun a concerted campaign of economic threats against the United States, hinting that it may liquidate its vast holding of US treasuries if Washington imposes trade sanctions to force a yuan revaluation.

Two officials at leading Communist Party bodies have given interviews in recent days warning - for the first time - that Beijing may use its $1.33 trillion (£658bn) of foreign reserves as a political weapon to counter pressure from the US Congress.

Shifts in Chinese policy are often announced through key think tanks and academies.

Described as China's "nuclear option" in the state media, such action could trigger a dollar crash at a time when the US currency is already breaking down through historic support levels.

It would also cause a spike in US bond yields, hammering the US housing market and perhaps tipping the economy into recession. It is estimated that China holds over $900bn in a mix of US bonds.
China has accumulated a large sum of US dollars. Such a big sum, of which a considerable portion is in US treasury bonds, contributes a great deal to maintaining the position of the dollar as a reserve currency. Russia, Switzerland, and several other countries have reduced the their dollar holdings.

"China is unlikely to follow suit as long as the yuan's exchange rate is stable against the dollar. The Chinese central bank will be forced to sell dollars once the yuan appreciated dramatically, which might lead to a mass depreciation of the dollar," he told China Daily.
The threats play into the presidential electoral campaign of Hillary Clinton, who has called for restrictive legislation to prevent America being "held hostage to economic decicions being made in Beijing, Shanghai, or Tokyo".


A bill drafted by a group of US senators, and backed by the Senate Finance Committee, calls for trade tariffs against Chinese goods as retaliation for alleged currency manipulation.

The yuan has appreciated 9pc against the dollar over the last two years under a crawling peg but it has failed to halt the rise of China's trade surplus, which reached $26.9bn in June.

Henry Paulson, the US Tresury Secretary, said any such sanctions would undermine American authority and "could trigger a global cycle of protectionist legislation".

Mr Paulson is a China expert from his days as head of Goldman Sachs. He has opted for a softer form of diplomacy, but appeared to win few concession from Beijing on a unscheduled trip to China last week aimed at calming the waters

Billion-dollar Indian companies

Company Name Net Sales (2008) in $ billion (conversion rate Rs.40.90 per dollar)
Indian Oil Corporation Ltd 52.53
Reliance Industries Ltd 25.76
Bharat Petroleum Corp Ltd 23.85
Hindustan Petroleum Corp Ltd 21.95
State Bank of India 9.73
Steel Authority of India Ltd 8.63
NTPC Ltd 8.04
Mangalore Refinery & Petrochemicals Ltd 7.04
Tata Motors Ltd 6.79
Chennai Petroleum Corp Ltd 6.07
MMTC Ltd 5.72
ICICI Bank Ltd 5.67
Hindalco Industries Ltd 4.51
Bharti Airtel Ltd 4.39
Larsen & Toubro Ltd 4.33
Tata Steel Ltd 4.33
Bharat Heavy Electricals Ltd 4.25
GAIL (India) Ltd 3.96
Tata Consultancy Services Ltd 3.68
Maruti Udyog Ltd 3.61
State Trading Corp of India Ltd 3.53
Wipro Ltd 3.37
Infosys Technologies Ltd 3.24
ITC Ltd 3.05
Hindustan Lever Ltd** 2.98
Sterlite Industries (India) Ltd 2.91
Reliance Communication Ltd 2.89
Punjab National Bank 2.84
Canara Bank 2.80
Adani Enterprises Ltd 2.50
Mahindra & Mahindra Ltd 2.48
Hero Honda Motors Ltd 2.44
Bajaj Auto Ltd 2.35
Bank of Baroda 2.27
Bank of India 2.26
Grasim Industries Ltd 2.14
JSW Steel Ltd 2.12
Hindustan Zinc Ltd 2.11
Ruchi Soya Industries Ltd 2.11
Videocon Industries Ltd*** 1.87
Ispat Industries Ltd 1.85
Union Bank of India 1.82
Ashok Leyland Ltd 1.77
HDFC Bank Ltd 1.70
Industrial Development Bank of India Ltd 1.56
Ambuja Cements Ltd** 1.55
Central Bank of India 1.54
Satyam Computer Services Ltd 1.54
Syndicate Bank 1.49
National Aluminium Co Ltd 1.46
Housing Development Finance Corporation Ltd 1.45
Indian Overseas Bank 1.44
Bongaigaon Refinery & Petrochemicals Ltd 1.43
ACC Ltd** 1.41
Reliance Energy Ltd 1.40
Petronet LNG Ltd 1.36
Suzlon Energy Ltd 1.33
UCO Bank 1.31
Oriental Bank of Commerce 1.27
Mahanagar Telephone Nigam Ltd 1.21
UltraTech Cement Ltd 1.21
Allahabad Bank 1.20
Jindal Stainless Ltd 1.20
Tata Power Company Ltd 1.16
Redington India Ltd 1.16
National Bank for Agriculture & Rural Development 1.15
UTI Bank Ltd 1.12
Siemens Ltd*** 1.11
Indian Bank 1.06
ABB Ltd** 1.05
National Mineral Development Corporation Ltd 1.03
ONGC# 9.75

* For manufacturing & service companies, net sales considered as revenue.For commercial banks, net interest income is considered as revenue.
** Firms’ financial year ending December 2006
*** Firms’ financial year ending September 2006
# For the nine months ended December 2006, ONGC’s sales were $9.75 billion. It has not yet announced its financial results for the full year. In 2005-06, the firm had recorded sales of $10.74 billion.

A bet on the dollar’s fall

Last week, I laid out a case for a weakness in growth prospects for the US economy, given the likelihood of trouble in its housing sector. It was not just a case of excess supply as more houses come into the market but also one of rising financial distress. Of course, financial markets are like our makers. They choose to mock at our seeming intellectual arrogance and contentment. Two sets of data in the US—the housing starts (laying the first brick or ‘breaking ground’) and the sale of existing homes— turned out far better than expected. Financial assets globally have breathed a sigh of relief. Indian readers would not have missed it either in their stock markets.

As has been their wont in the last two/three years, investors have developed a remarkable tendency to look at the sunny side of things. The confidence of US home builders declined rather sharply in March. Most experienced investors would view that as a forward-looking indicator of how the housing market would develop, rather than feeling relieved at the sale of homes (new or old) in the previous month. In addition, US leading indicators fell sharply in February and the small positive number in January gave way to a negative change. Therefore, we have had two consecutive months of sizeable declines in the leading indicators. As this indicator has a good track record of presaging recessions in the US, one must attach a high probability of a recession in the US in the coming two/three quarters. But investors ignored this data as it didn’t fit into their sunny framework.

Similar was their disposition towards the communication released by the US Federal Reserve. The committee in the American central bank (equivalent of India’s RBI) that decides on official interest rates made no change to the key, short-term rate for overnight loans to banks, at 5.25%. That was no surprise. They made some important changes to their press statement. Hitherto, they had felt that the next move in rates was more likely to be up than down, and that the only undecided elements were the timing and the magnitude of such an increase. They dropped that line. At the same time, they insisted that they were concerned about inflation remaining above their “comfort” levels (2.7% vs 2%). Importantly, they changed their assessment on US housing from “stabilising” to “ongoing adjustment”.

While certainly this means that they are open-minded on the next move in interest rates, they were also hinting at the potential combination of high inflation and slowing growth. Economists’ contribution to the English dictionary is to come up with a term called “stagflation” to describe such a combination. Perhaps, it was too abstract to register in investors’ minds. Consequently, share prices jumped on the Fed taking their finger off the interest rate button. The US dollar weakened, as it should.

What the leading indicators suggest is that the economy could slow down significantly. The Federal Reserve has expressed a dilemma. But, the American central bank, being a politically-sensitive institution, would be forced to drop interest rates regardless of whether inflation was above or below their comfort zone. Past form indicates that too. If the past is no guidance to the future and Ben Bernanke (the chairman of the Federal Reserve) is less inclined to ride to the rescue of avaricious mortgage lenders, ignorant borrowers and their willing collaborators on Wall Street as his predecessor used to do, then the risk is that the growth gloom is stark. Therefore, whichever way we slice the argument, the US dollar has to fall quite a bit against other currencies.

America is usually sanguine about US dollar declines. After all, it is a large economy and imported inflation because of a cheap currency is a remote threat. Further, all its debt is denominated in US dollars and hence a falling dollar is a legitimate way of defaulting on the debt while the burden falls entirely on lenders. These are additional reasons to bet on a dollar weakness in the months ahead.

Exchange rates are about relative fundamentals and not just about the darkening clouds on America’s economic horizon. Much could be written about equally bleak and more long-term economic prospects in the Eurozone. The proportion of economically active population (15-59 years) in 2050 would be less than 50% in Italy and in Germany, whereas it would be 56% in the US. That is vital for innovation, creativity, entrepreneurship and productivity.

Therefore, what do investors do when all currencies face short-term and/or long-term challenges? Well, in these times, it is not going to hurt at all to load up on gold and silver and there is the bonus of a happy home that comes along with it.

V. Anantha Nageswaran is head, investment research, Bank Julius Baer (Singapore) Ltd.

Currencies: A Retrospective on 2006: A Cyclical Dollar Downturn

Stephen Jen | London

This is a time for reflection on 2006

I am saving my 2007 outlook for the first week of January. Instead of looking ahead, I think it is useful, at the end of the year, to take a moment to reflect on the year that has just gone by, and to evaluate my calls this year and draw lessons from how the currency markets behaved this year.

What I said at the beginning of the year

1. “The story for the dollar this year will be cyclical and closely linked with the developments in the US housing market.” I argued that the ‘trendy’ phase was over and for 2006, I saw a “gentle turn in the dollar in sync with a soft-landing in the US housing market. I also argued that the US current account deficit would reach an ‘inflection point’ in 2006, which should diffuse much of the angst about the dollar from a structural perspective.

2. “2006 will be the Year of the CNY. More flexibility and more meaningful appreciation of the Chinese currency are expected.” As the CNY appreciates, it will push all the Asian currencies stronger against the dollar. JPY will be the laggard in this bunch due to its very low yield … China will become the largest foreign reserve holder in the world later this year, surpassing Japan.

3. “The dollar’s movements this year will likely be asynchronous against various currencies.” “In contrast to the previous four years, the dollar’s movements are likely to be asynchronous against different currencies. In other words, the USD is likely to peak at different points in time against various currencies.

My good and bad calls this year

In my view, my call for a cyclical dollar correction centered on the US housing market has been broadly correct. I argued a year ago that EUR/USD was forming a bottom in the 1.17-1.18 range. I was also correct in expecting USD/AXJ, led by USD/CNY, to trade lower this year, with USD/JPY being the laggard due to the low yields in Japan. Importantly, my prediction that the US current account deficit would reach an inflection point this year also seems to be correct.

I was, however, wrong on several fronts. (1) I had underestimated the market’s support for EUR/USD and the ability of the Euroland economy (Germany in particular) to recover. (2) In contrast, I was too aggressive on USD/JPY this year, thinking that USD/JPY would go on being weighed down by positive real economic fundamentals, and that the relative low nominal yields would matter less over time. (3) I underestimated the scope for EUR/JPY to trade higher. Even though I proposed the ‘Global Funneling’ concept as an explanation for this upward structural drift in EUR/JPY, I did so quite late (August). (4) I had expected the three commodity currencies to depreciate against the dollar, as the global economy decelerated with the US, and because these currencies were already over-valued. Further, I had expected that the prospective unwinding of the JPY carry trades would weigh on these high yield commodity currencies.

Lessons from 2006

There are several key lessons from 2006 that will be important to keep in mind for 2007.

• Lesson 1. Financial globalization will remain a powerful driver of exchange rates. By financial globalization, I mean the sharp rise in cross-border capital flows, both private and official, in recent years. Trade balances and globalization of the goods markets are clearly important, but I believe that capital flows and financial globalization are even more important in dictating where exchange rates go.

First, it has been a global trend that ‘home biases’ have declined in most countries. This has made current account imbalances a much less powerful predictor for exchange rates.

Second, as virtually all countries are diversifying, it has been difficult to draw clear, definitive conclusions for currencies. As a result, investors have thus been forced to extrapolate from announcements made by a few central banks and countries that are unfriendly toward the US, such as Iran, North Korea and Venezuela. My view on this subject of central bank diversification is quite different from popular opinion in the market, but I concede that since the prevalent view can neither be proved nor disproved, comments and rumors will continue to fuel bouts of mini-attacks on the dollar, interrupted by sporadic surges in the dollar based on economic fundamentals.

Third, as the official reserves of several key central banks in the world exceed what are needed for liquidity purposes, many central banks will likely deploy the additional or new foreign reserves to investments that are higher-risk but with higher expected returns. This evolution from pure reserves to the ‘sovereign wealth funds’ has begun, and will have very significant implications for not only the currency markets but also bond and equity markets in the years ahead.

Fourth, in thinking about the fair values (FVs) of exchange rates, it is also important to consider a concept I proposed several years ago: Multiple Shadow Prices. The basic idea is that, while most fair value calculations, including ours, are based on real economic fundamentals, given the importance of global capital flows, a parallel concept is that some countries may have very different exchange rate FVs, from the perspective of capital markets.

• Lesson 2. Cash yield differentials will likely remain important. I have long resisted accepting that nominal cash yield differentials could be such the dominant driver for exchange rates. To me, over time, real economic fundamentals (such as productivity and the terms of trade) should be important and carry should not. How the currency markets have behaved in 2006 suggests otherwise, however.

First, cross-border asset holdings have grown drastically in recent years, the need to hedge should also have increased. Since hedging costs are dictated by nominal short-term interest rates, cash yield differentials may have become a more powerful driver than in the past.

Second, I have recently realized that the sensitivity of exchange rates to nominal cash interest rates may also have been due to the enhanced transparency of central banks in their communication strategy.

• Lesson 3. Don’t bet against the Fed. To me, the Fed has been the best forecaster of the US economy. At virtually all turning points since 2002, the Fed has been ahead of the market and made the correct call. I am not saying that the Fed does not make mistakes, but merely pointing out: (i) the remarkable level of confidence the Fed’s detractors have in this environment of uncertainty; and (ii) the recent superior track record of the Fed, compared to anyone else in the market.

• Lesson 4. Beijing to be more flexible in the years ahead. I believe that the single most important development in China this year has been the explosive growth in its trade surplus. There is no way around: (i) China’s additional reserves being converted into a ‘sovereign wealth fund’; and (ii) the rate of crawl of USD/CNY accelerating further.

• Lesson 5. Don’t underestimate any economy, even Euroland. Back in early 2005, Japan surprised many with its economic recovery, as did Germany a year later. The point here is that a lesson I have learned is not to dogmatically cling to preconceived notions: a structurally flawed Euroland can exhibit surprising resilience. The durability of the recovery we are witnessing is the next test for Euroland, but commentators (like myself) and investors should be open-minded about this.

Bottom line

Many of the key themes that have dominated this year will likely carry over to 2007. I will present my 2007 currency outlook in more detail early next year.