Forex Forecast- try saying that three times fast! The Market Oracle, an online financial publication, has done even better, preparing a one-year forecast for all of the major currencies along with a detailed analysis of the major factors driving each currency in the month of February. The Dollar and Yen are projected to be the strongest performers in this time frame, benefiting from a trend towards risk aversion.  It should be noted that this prediction is consistent with news reported by the Forex Blog earlier this week. On the other hand, currencies that have been propped up by the Yen carry trade, namely those of Australia, New Zealand, Canada and South Africa, will face selling pressure.  The British Pound is projected to underperform slightly, due to an easing of British monetary policy, which will narrow the interest rate advantage claimed over the US.

Finally, the Euro is something of a wildcard.  On the one hand, the EU economy is stagnating, and the ECB has hinted that rate cuts are a possibility. On the other hand, the Euro theoretically stands to inherit a significant amount of risk-averse capital, especially from foreign investors looking for a stable alternative to the Dollar.  Accordingly, the Market Oracle forecasts a short-term decline in the value of the Euro but a long-term appreciation.

Read More: Currency Market Strategy and Forecasts for February 2008

In its annual meeting, the G7 virtually ignored the situation in forex markets.  In previous years, the G7 used the so-called "communique," which essentially functions as a summary of the meeting, to rebuke China for not allowing the Yuan to appreciate at a satisfactory pace. This year, the RMB has appreciated markedly- by 9% on a trade-weighted basis- and thus, the G7 opted not to apply further rhetorical pressure.  In addition, several of the most prominent EU member states had hoped to work a discussion of the Dollar into the communique, but alas, any mention was notoriously absent. Analysts have speculated that this is due both to America's political indifference towards the valuation of the Dollar as well to a disagreement over what the correct valuation should be, if indeed it is undervalued. Thomson Financial reports:

"It was clear a few days ago that there was going to be no change in the (currency section) of the communique and that really spoke of a lack of consensus about mainstream currencies."

Read More: China spared ritual lambasting as yuan slips down G7 agenda

Last week, the USD recorded its best weekly performance since 2006, rising 3 cents against its chief rival, the Euro.  Apparently, analysts are becoming increasingly pessimistic about the effect of the America recession on the global economy.  The consensus is now that a dampened global economy will induce a trend towards risk aversion, which favors the world's #1 and #2 reserve currencies, the Dollar and the Euro, respectively.  However, it also appears the near-term economic prospects for Europe are less rosy than originally forecast,.  Thus, if last week is any indication, the Dollar should receive a larger proportion of risk-averse capital. Reuters reports:

"Despite a torrent of bad economic news the dollar has been on a tear this week, as the currency market recognized the fact that the slowdown in U.S. economic activity is likely to drag down growth in the rest of the G10 universe..."

Read More: Dollar set for biggest weekly rise since June 2006

At its meeting last week, the European Central Bank (ECB) held its Euro-zone benchmark lending rate at 4.00%.  While the decision itself came as no surprise, analysts were nonetheless waiting with baited breath to hear what remarks would accompany it.  Jean Claude Trichet, the Bank's President, eased up on hawkish comments he made the previous month, when he signaled that his primary concern was inflation rather than the risk of economic recession. This month, however, he changed his rhetoric markedly, indicating that the ECB was less willing to preempt rising price levels and would instead shift its focus to the possibility of a 'sharp slowing' of EU growth. Forbes reports:

Our view [is] that rate hikes are definitely off the agenda at this stage and by bringing a greater degree of uncertainty on the growth assessment, the ECB may be getting ready for a shift towards a more dovish policy language.

Read More: Euro sags after Trichet tones down hawkish stance

As talk and evidence of a US economic recession builds, the Dollar has witnessed a slight upswing.  How to explain these seemingly contradictory trends? The rationale is surprisingly simple.  While a US recession would predictably hit the US harder than other countries, it would still hamper growth abroad, especially in emerging markets that have come to depend on exports to the US to drive growth.  Accordingly, investing in such emerging markets becomes relatively more risky than investing in the US, which is still considered to have the world's most stable investing climate from a long-term perspective.  Thus, as risk aversion rises, so does the Dollar. Thomson Financial reports:

The combination of poor data weighed on stock markets in the US and Asia, while major bourses in Europe have all opened lower today. This meant the dollar gained support as investors shy away from riskier emerging market assets.

Read More: Dollar gains on the back of rising risk aversion

China's foreign exchange reserves currently approximate $1.5 Trillion, the majority of which is denominated in USD.  Moreover, the Central Bank of China earns interest on every Dollar it adds to its reserves but must also pay interest on every RMB note that it must issue to offset the Dollars. Since the Fed began easing monetary policy, the amount of carry (the difference between what the Central Bank receives on Dollars and pays on RMB) earned by the Central Bank has completely inverted, such that it now loses 250 basis points on average for each Dollar exchanged for RMB. 

Based on the rate at which China is currently accumulating reserves, this amounts to between $5 Billion and $10 Billion per month, depending on which method of accounting is utilized. Furthermore, this trend has been exacerbated because China is accumulating reserves at a faster rate than its economy is growing. Some analysts have speculated that this could turn into a major political issue, with important implications for the RMB/Dollar exchange rate. The Financial Times reports:

The renminbi has started to appreciate more rapidly in recent months, rising at an annualised rate of about 20 per cent, compared with 6-7 per cent over the whole of 2007.  In the longer-term, say economists, China will have no choice but to allow its currency to appreciate faster, even in the face of entrenched domestic resistance.

Read More: Beijing starts to pay for forex ‘sterilisation'

It seems self-evident that the Fed is easing monetary policy because it is trying to stimulate the economy and shore up confidence in capital markets by making credit less expensive.  Dig a little deeper, however, and a more nuanced picture begins to emerge.  Conspiracy theorists believe that the Fed knows something that investors don't, perhaps that the subprime mortgage situation is more serious than the public is being led to believe. Accordingly, the theory goes, it is trying to prevent a complete collapse of the financial system.  Another theory holds that the Fed is cutting rates because it has nothing to lose by doing so. Inflation is still low, from a historical standpoint, and the Fed may be trying to inject liquidity into the financial markets before it is too late.  Yet another theory holds that the Fed is deliberately targeting a weak Dollar and high commodity prices, as the former benefits the US directly by narrowing the trade imbalance, and the latter benefits the US indirectly by helping emerging market economies, which are relatively more dependent on commodities.  The Chicago Tribune reports:

An increase in exports was one of the positive features of Wednesday's disappointing fourth-quarter report on U.S. gross domestic product. The cheaper dollar is a major factor in export growth, both in terms of current sales and expansion of overseas market share by U.S. manufacturers.

Read More: Fed rate cut conspiracy or power play?

Those who make a living tracking and betting on the foreign exchange reserves of Central Banks officially have a new player to keep tabs on: India.  Nearly 17 years ago, India's reserves dipped below $1 Billion, and government ministers began sounding the alarm bells. In comparison, fiscal 2007 witnessed a rise of $47 Billion in India's reserves, bringing the total to $280 Billion.  The government is projecting an even greater increase in 2008, estimated at $100 Billion.  Now, the challenge is what to do with all of the reserves; investors will be tracking developments in this regard because of the implications for the currencies of which the reserves are denominated in.  The Dollar and Euro are currently jockeying for position; while the Dollar is way ahead, the Euro is quickly closing in.

Read More: India expects to add $100 bn to forex reserve in FY'08

Most of the world's major currencies are affected by a variety of technical and fundamental factors, such that only taking into account one factor is tantamount to using P/E multiples as the sole basis for purchasing shares of stock. The New Zealand Dollar, which barely qualifies as a major currency seems to be one of the few exceptions to this common sense rule.  The preponderance of carry traders involved in trading the Yen ensures that the NZD inversely tracks the Japanese Yen.  In addition, the demand for Kiwi is directly proportional to appetite for risk, such that when risk aversion declines, the Kiwi increases, and vice versa.  The reasoning is quite simple: the Kiwi boasts the highest interest rates in the industrialized world. Because the investment climate in New Zealand is less stable than in other industrialized countries, New Zealand often witnesses capital flight during periods of global economic uncertainty.  The New Zealand Herald reports:

Gains in equities markets emboldened investors to take chances, prompting use of the low-yielding yen to buy assets in higher-yielding currencies like the kiwi in carry trades.

Read More: Equities send dollar up

As far as Dollar bulls are concerned, all news is bad news. An economic recession seems inevitable. Interest rates are already negative in real terms, and are now the lowest in the industrialized world, save Japan.  It's still unclear how much subprime debt will be written down by financial companies before all is said and done.  But analysts from Brown Brothers Harriman, an investment bank, think the Dollar's multi-year decline is coming to an end.  There are two main reasons underlying their rationale.  The first point is purely technical- that the all of the bad news and in fact, the worst possible scenario, has already been priced into the Dollar.  The second point is fundamental- that the speculative hot money that has poured into the US as foreign investors take advantage of a weak Dollar and that is sustaining the US current account deficit is now transitioning into long-term foreign direct investment.  The Financial Post reports:

In addition, BBH believes that in a weak dollar environment, foreign companies will now start looking to move production and sourcing to the United States, following the successful example of Japanese auto makers.

Read More: Greenback is nearing bottom, currency experts say