Vassili Serebriakov, FX analyst at 4CAST Inc., sees a change for forex traders in 2008.

“I think 2008 is not going to be about straightforward plays like the carry trade or a simple short bet on U.S. dollar weakness,” he says. “It’s going to be about relative-value trades.”

4CAST Inc. is forecasting aggressive and early rate cuts by the ECB. While most of the market expects a June rate cut, 4CAST Inc. expects a 25-bp cut at the March meeting, which would tug the repo rate to 3.75 percent.

“In terms of rate cuts, the euro doesn’t have much priced in,” Serebriakov notes. “The ECB has been consistently hawkish thru the credit turmoil, but we think they will not be able to avoid cutting rates.”

This could present interesting opportunities in various euro cross rates, according to Serebriakov.

“There is an argument the euro crosses are quite expensive,” he says, citing the euro/Swiss (EUR/CHF) and euro/Aussie (EUR/AUD). “If the ECB comes in with rate cuts faster than the market expects, the euro could weaken vs. the Swiss franc and the Aussie.”

Shifting back to the greenback, most currency analysts seem to agree that a midyear U.S.-dollar turnaround is likely, with a decline in the euro/dollar pair (UR/USD) to the 1.40 level by year-end.

However, no one has a crystal ball.

“We know what the risks are,” Credit Suisse’s Basile says. “It is just a matter of time to see how the cycle plays out.”

China has the wherewithal and will to do whatever it takes to prevent an even more dramatic economic downturn. Since September, the benchmark oneyear lending rate has been cut 216 basis points to 5.31 percent, and additional cuts are expected as early as next month.

There is plenty of scope for fiscal stimulus as well. China’s budget deficit last year was about 180 billon yuan — less than 1 percent of GDP. Debt levels are also modest by international standards. It’s already-announced 4 trillion yuan stimulus package consists largely of previously announced or intended programs; additional spending programs and tax cuts are likely. The Ministry of Finance’s Research Institute for Fiscal Science projects China’s budget deficit to be 3 percent of GDP this year.

However, China continues to invest at an incredible pace. Fixed investment in urban areas rose 26.1 percent last year after a 25.8 percent increase in 2007. This is in stark contrast to the U.S., where investment was exceptionally poor during the recent expansion phase; company borrowing mainly went toward stock repurchase schemes.

China’s problem appears just the opposite — investing too much and being terribly inefficient. It has reached the point of diminishing returns, with growth slowing to 9 percent in 2008, down from 13 percent in 2007 despite an increase in factories and equipment. The excess investment led to excess production, which resulted in a severe oversupply of manufactured goods.

Although it is difficult to discern from press reports and congressional rhetoric, in recent years the U.S. Treasury has pursued a wider range of issues with China than the bilateral currency rate. The U.S. has encouraged China, through a commitment to a stronger social safety net (including healthcare and unemployment compensation), to boost domestic consumption and raise labor costs.

And as Geithner was talking tough about currency manipulation, China was earmarking 850 billion yuan over the next three years to reform its healthcare system. Currently the Chinese government accounts for about 42 percent of the country’s healthcare expenditures which, when compared to figures of 49 percent in the U.S. and 87 percent in the UK, puts China in the lowest quartile of countries according to the World Health Organization. The cost of the program is reported to be approximately equal to the country’s total healthcare expenditures in 2005.

Some analysts contend exotic currencies tend to trend better than the majors because their economies are often narrowly focused, or even dependent on one specific industry or investment theme.

GFT Forex and Oanda.com currently include exotic currency trading on their retail trading platforms.

“Exotic currency pairs provide traders with the ability to take advantage of trends that can be established by large money taking positions in these less-liquid currencies,” says Paul Jamgotch, dealing desk manager at GFT. “Exotics are also attractive to traders who keep their eyes on the fundamental factors that can affect these smaller financial markets. Also, it gives retail traders a way to speculate in the economies of countries that don’t offer easy access to other trading vehicles, such as bonds or stocks.”

Diversification is another argument in favor of expanding into the exotic arena.
“Having exposure to just the major pairs really narrows the scope of a trader’s portfolio,” says Richard Lee, currency strategist at FXCM. “Portfolio returns in emerging markets are also outpacing major-currency investments.”

While FXCM currently does not provide access to emerging market currencies on their retail platform, they do provide research in the Hong Kong and Singapore dollars, as well as the Chinese yuan.

“Additional instruments are good because they offer diversification,” says Richard Olsen, co-founder of Oanda.com. “Anyone trading any market wants to diversify.”
Oanda gradually began adding exotic cross rates to its retail platform starting in 2006 and Olsen says it has been met with “an astonishing amount of interest.” Oanda has a fairly wide offering of exotic currency crosses, including crosses with the euro dollar vs. emerging market currencies.

(For a list of Oanda’s current exotic pairs offerings see:
https://fxtrade.oanda.com/spreads/all_spreads.shtml.)