A Huge Upset Coming in 2008...Part II

Joined : 23 Dec 2007 Posts : 241 Location : Nigeria

Today's commentary is by Sean Hyman, our Currency Director and editor of The Money Trader.

Happy New Year Currency Traders!

As I said yesterday, a huge upset is coming this year in the U.S. dollar.

But that's not all. Currency insiders, including myself and my esteemed colleague Jack Crooks, see all the beaten down currencies, including the U.S. dollar, Japanese yen and even the Swiss franc rallying later this year. And as these low-yielding currencies rise, the Dow Jones Industrial average will drop like a rock.

Also, look for the euro and the pound to fall vs. the Japanese yen (EUR/JPY and GBP/JPY) in response to the drooping Dow this year. I say this because the Japanese yen always benefits when these stocks fall.

On the flipside, dropping stocks take the biggest toll on the most "lofty" of high-yielding currencies like the euro and pound. So if the Dow falls, the Japanese yen will rise - against both the euro and the pound.

Carry-Trades Come Back to
Haunt Ambitious Traders

Meanwhile, also look for the euro and the British pound to fall against the Swiss franc (EUR/CHF and GBP/CHF).

The Swiss franc is one of the leading lending currencies to the now infamous "carry-trade." Traders have borrowed low-yielding Swiss francs to invest in loftier, riskier assets.

But this trading strategy will come undone later this year in this volatile market. That means traders will have to buy back the currencies they borrowed to fund their carry-trades.

Unwinding "carry-trades" will first benefit the most popular "carry-trade" currency, the Japanese yen, then the Swiss franc and finally the U.S. dollar.

Why Will this Happen?
Global growth is slowing and the high exchange rates in Europe and Britain are taking a toll on the export segment of their economies.

The high interest rate environment has also hurt the European and British economies. This will also force their currencies to weaken. Traders will dump euros and pounds that they bought with carry-trades. When that happens, traders will use that money to buy back low-yielding Japanese yen and the Swiss franc.

So as the Dow crumbles, expect the EUR/JPY and GBP/JPY in particular to go down in concert with it. Other carry-trades will falter as well. However, these are the "best" candidates.

The EUR/JPY will break out of this coiling triangle to the downside as this all unfolds. A coiling triangle pattern is where the "highs" grow lower AND the "lows" grow higher. This leads to lower and lower volatility in a currency pair as the pattern grows towards the tip of the triangle. Once it breaks out, it breaks directionally with an ever-increasing volatility. See the chart below.

Carry-Trades Sink - and Force the
Euro to Fall Against the Yen

As these European economies slow down, you'll see more central bankers cutting rates. Once that happens, carry-trades will just come unraveled faster.

These carry-traders have held long-term positions for years, so it will cause a massive sell-off once traders catch on to the unraveling carry-trades.
To Wrap Up...
To recap: 2008's big winners will be the Japanese yen, Swiss franc and U.S. dollar (possibly in that order too). Meanwhile, the euro and British pound will sink and catch many by surprise.

Note also that I wouldn't touch the USD/JPY or USD/CHF as a long-term outlook. Playing the dollar against either the yen or the Swiss franc just doesn't make sense at this point. Each currency individually could benefit from 2008's market environment on its own. But when you pair them together, you won't see as big of an impact (or as big of gains) as playing these low-yielding currencies vs. the pound or euro.

The public, media and most traders won't catch these trends until much of it is already over. However, consider this your "heads up" ahead of time.

Here's Wishing You a Happy and Prosperous New Year!
Sean Hyman, Currency Director