Forex Journal

In the time it takes for this article to be written, submitted, edited and published, the financial markets could look entirely different from how they do at the time of writing. Just as this introduction is being penned, political leaders are locked in discussions and wrangling for the long-term survival of the Eurozone.  It is pure speculation at this stage whether European leaders can successfully defend their Eurozone model, and there may well be more chapters in the sovereign debt saga to come – but either way, the outlook for the currency market is pretty exciting. 

It is interesting to consider whether next year we will be heralding in the return of the mark, drachma and peseta into our currency discussions or saying farewell to some currencies whose countries opt to join a new, super-Eurozone.  Whatever the outcome, the success of Europe’s survival plans will have huge implications on the trends that will define the next 12 months.  That is not to say there are not some key story arcs in play that have the potential to become major themes in the new year.  In this article, we will discuss our predictions for the year ahead, and what stories will occupy currency markets throughout the course of 2012. 

Low global interest rates and high volatility will kill the carry trade.

The global easing cycle has already begun in late 2011.  Among the G-10 economies, Australia’s 4.25% cash target stands among the highest interest rates offered and that level is already under pressure from fears of a global recession. Australia’s hugely influential trading partner, China, is experiencing stuttering industrial production growth and the symptoms of a slowdown, and there are very few bright spots on the horizon that have the potential to reverse this trend. The easing bias is not just confined to commodity-sensitive Australia.  

Both the Reserve Bank of Australia and European Central Bank cut interest rates in December; both citing fears of a massive slowdown in global growth and enormous vulnerability in the financial sector.  It would be lovely to think that policymakers will be able to conceive that magic bullet which will solve Europe’s debt crisis and steer global growth away from a double dip, but a quick fix seems like wishful thinking at this stage.  As such it is doubtful that these rate cuts will be quickly reversed in the new year, or that central bankers are anticipating these cuts are merely a one-off treatment.  Instead, the reality is that 2012 will almost certainly get off to a tough start and more rate cuts are likely from the Reserve Bank of Australia, European Central Bank and others. 

Against this backdrop of dwindling interest rates, the appeal of the Forex carry trade erodes. There’s less cushion provided from yield differentials to counteract any adverse movement in the exchange rate.  What is more, the hugely uncertain outlook in 2012 means it is likely that such adverse volatility in exchange rates is likely to be more, not less than it was in 2011.  As such, the success of carry strategies will suffer even more by marked increases in volatility prompted by continuing uncertainty and dramatic political change.

This is an excerpt from Jan 2012 issue of Forex Journal.