Guy Gengle, vice president of dealing at Global Forex Trading (GFT), points to the U.S.dollar/Canadian dollar (USD/CAD) as a hot trade to watch. Over the longer-term, Gengle says “I don’t think you can negate the weaker (U.S.) dollar.”

A look at a daily USD/CAD chart reveals a steady and strong downtrend in the USD, and the CAD at its highest level vs. the buck in more than a decade.

As of mid-November, the USD/CAD had pushed to a new low at the 1.18 area. Gengle sees potential for a short-term corrective bounce in the dollar, vs. Canada, which could offer short-term traders plenty of opportunity, he said. A corrective rebound could see USD/CAD bounce up toward the $1.22/1.23 zone, Gengle speculates.

Looking beyond any market correction, however, the longer-term downtrend in the U.S. dollar vs. the Canadian dollar was likely to resume, Gengle says. On the downside, he highlighted the $1.18 area as a “big level.”

Declines through that floor could open the door to further depreciation, perhaps even as low as $1.12/1.13.

Sean Callow, currency strategist at Ideaglobal, offers another top cross rate pick. He points to the AUD/USD as a hot cross to watch. A daily chart reveals the Australian dollar has been screaming higher vs. the U.S. dollar in recent weeks. The cross rate soared from a low at 68.53 in early September to the 78.45 area in mid November.

First, Australia is boasting an interest rate of 5.25 percent, or the second highest in the industrialized world right now.

“That is a good solid yield for anyone to be sitting on right now,” Callow says.

Also, the country is enjoying solid fundamentals, including a strong domestic economy lately, with unemployment in October hitting its lowest level (5.3 percent) since 1978. Gross domestic product growth is expected to remain robust in the 3.5 percent area.

“The strong domestic economy underpins the relatively high interest rates, with no fears of a rate cut,” Callow says.

Another factor supporting additional gains in the AUD/USD is the rising cost of exports. Australia is a major exporter of coal, wheat, natural gas, gold and steel. The Reserve Bank of Australia estimated its commodity price has risen 16 percent year-over year, as of October.

“That directly helps Australia’s export revenue,” Callow explains. Callow also notes that speculators looking for a place to put on bearish trades on the U.S. dollar have an advantage of buying the Aussie dollar because, “you get a decent yield pickup and are not likely to face a central bank on the other side. The Reserve Bank of Australia does intervene at times, but generally it is small scale. They will not be trying to take on the market.”

Near term, Callow sees the AUD/USD testing the 80.00 mark, possibly before year-end. If that level cracks, Callow expected additional upside momentum toward the 82.00 or 83.00 area by first quarter 2005.

Wondering what the most active and interesting forex rates to trade right now are?

Currency Trader asked three analysts for their top cross rates heading into the New Year and they chose AUD/JPY, AUD/USD, and USD/CAD.

According to Brian Dolan, director of research at Gain Capital, action in the AUD/JPY could prove interesting over the next several months. While AUD/JPY had, as of mid-November, pushed to its highest level (around 81.75) since March 2004, Dolan highlights a number of fundamental and technical factors that could make that trend switch gears. Generally, Dolan favors selling the Australian dollar vs. the yen.

While fundamental factors are positive for both of these currencies, Dolan believes the yen is more likely to appreciate amid “potential for revaluation of the Asian currencies,” which would allow the yen to strengthen, he says. While many Asian countries, notably China, have been able to artificially keep their currency levels relatively weak despite robust growth, “the next major shift will likely see these currencies appreciate,” Dolan says. Any strengthening of the Chinese currency would probably spill over to the yen.

A second factor likely to support a retreat in the AUD/JPY rate over the next several months is a decline in “uridashi” issuance, Dolan speculates.

Uridashi refers to non-yen fixed income instruments sold to Japanese investors. Uridashi denominated in Australian dollars have been a popular choice among Japanese investors, simply because of higher Aussie interest rates. However, “uridashi issuance peaked in 2003 and is expected to decline further this year,” Dolan notes.

As the Japanese economy continues to show signs of improvement, Japanese investors may choose to keep their investment dollars at home. If the decline in uridashi issuance continues, the demand for Aussie dollars will decrease.

Finally, Dolan highlights a potential head-and-shoulders top formation on the monthly AUD/JPY chart as a negative factor. Dolan says as long as the 82.50 resistance area (established by a trendline connecting the tops of the two shoulders) holds, he looks for an eventual retreat back to approximately 74.00/75.00 (the level of the pattern’s “neckline”) over the next six months.

Looking at the charts, Rogers highlights key levels for forex traders to watch on the downside. He points to the bottom coming in at $1.8393.

“We bounced off the bottom three times in the past two weeks,” he says. “If we go below that level a lot of people will start to think the uptrend is over.”

Andrew Chaveriat, technical analyst at BNP Paribas, also says the key level on the upside is $1.8770, the July high.

Gains through that key resistance point would target a retest of the $1.91 area, he says.

“I would be bullish at this point and buy these dips,” he says.

He also highlights the $1.83 area as key to watch on the downside.

“A close under there would signal a deeper retracement,” Chaveriat concludes.

However, given the market’s general acceptance that the tightening cycle is likely over in Britain, action in the sterling may, at least in the short-term, be driven by the direction of the U.S. dollar. “As opposed to developments in the UK, the key hinge point for the pound is the dollar,” Lynch says.

Thomson Financial’s Rogers expects the pound to test the $1.88/1.90 area before the year is over.

“I don’t think the dollar sell-off is over yet,” he explains.

While Rogers is upbeat on the outlook for the pound, he does note that recent gains in the sterling have not kept pace with euro and Swiss franc strength.

“Because rates are likely on hold, it is definitely holding the pound back from making stellar gains,” he explains.

Renewed weakness in the U.S. dollar, which saw the euro push to all-time highs in the $1.30 area, have helped support sterling in recent weeks, analysts say.

Another factor that supported the pound from mid-October to early November was reserve shifting from dollar assets into the pound by the Bank of India. However, Rogers notes as of mid-November they stopped buying sterling.

The key question for forex traders is: what will the end of BOE rate hikes mean for the pound, which has been stuck in a narrowing consolidation? From an interest-rate differential standpoint, Credit Suisse First Boston’s Stephansen notes “the ECB [European Central Bank] hasn’t begun hiking yet. Since the BOE is at the end of its tightening cycle, this policy divergence could bring a correction to the sterling.”

ECB left rates steady at its early November meeting at 2.00 percent. ECB President Jean Claude Trichet highlighted improvements in economic strength in the euro zone area, but warned about the negative impact from higher oil prices. The ECB’s only mandate is to ensure price stability.

The inflationary impact from stronger energy prices could move the central bank to raise rates there.

What has this meant for the British pound? The sterling soared to a 12- year high at $1.91 in February 2004, driven in part by aggressive BOE rate hikes and the positive interest rate differentials those hikes created for the currency.

However, since February, the pound-dollar rate has formed a triangular consolidation pattern on the weekly chart with the most recent swing-high resistance around $1.87 and swing-low support around $1.77. As of mid-November, the pound had edged toward the upper end of that range and is poised to test resistance at the $1.87 area.

After a series of aggressive rate hikes over the past year, the Bank of England (BOE) held its repo rate steady at 4.75 percent at its Nov. 4 meeting. Many analysts believe this may mark the end of the tightening cycle in Britain — at least for now. The next meeting is set for Dec. 9.

“The BOE inflation report was a bit less concerned about inflation going forward,” notes Bob Lynch, currency strategist at BNP Paribas in New York. “We do think the tightening cycle is complete.”

Analysts point to signs the housing market is cooling off in Britain as one factor that could keep the BOE on the sidelines in the months ahead.

Housing prices have stopped rising and by some measures have even registered declines in recent months.

Although housing-price inflation still registered a hefty 13.8 percent year-over-year increase in September, actual housing prices declined -0.1 percent during September, according to the UK Office of the Deputy Prime Minister (ODPM). However, the key point for the BOE is “the rate of increase has decelerated substantially,” Lynch says. “We had been seeing price increases at a 20-percent per year rate.”

In terms of overall growth in Britain, Kathleen Stephansen, director of global economic research at Credit Suisse First Boston, says the economy isn’t doing too badly. While a soft patch was seen in the third quarter with a 2.2-percent growth rate, Stephansen forecasts overall GDP growth at 2.8 percent in the UK in 2005. BNP Paribas’ official forecasts for 2005 GDP growth are slightly lower at 2.5 percent. “They’ve had a very strong economy over the past few months,” says Tom Rogers, senior currency analyst at Thomson Financial. “They are growing stronger than the rest of Europe.”

In other economic news, the UK trade deficit narrowed sharply in September to 4.5 billion pounds from 5.2 billion pounds. Analysts point to an 11-percent jump in exports to non- European Union countries as the key factor behind the shrinking gap.

Broad-based improvement occurred, with impressive gains to Asia, including a 15-percent increase to China and 27-percent increase to Japan.

Shifting gears to the other high-yielder down under, the Australian dollar (AUD) has been range-bound since May, but was bumping up against the top of the range in mid-October. After soaring to its 2004 peak at 0.8005 in February, the AUD retreated into a clear-cut sideways range between roughly 0.6770 and 0.7370 in the May- October period.

“We may see a little more strength in the commodity currencies, like the AUD, but it is kind of a last gasp,” warns Solin. “There may be some life left in that trade, but not much. The risk is that you’ll see the latecomers come into that trade and that is it.”

Pointing to the economic outlook in Australia, Thomson Financial’s Rogers notes “people are getting a little nervous about where the Aussie economy is going to go. The fear is that China will slow down and they are Australia’s third largest trading partner.”

The overnight cash rate stands at 5.25 percent in Australia, with the late rate hike seen in December 2003. Looking across the foreign exchange markets, Rogers points out that recently “all the major currencies have made new highs in the last run lower in the U.S. dollar. But, the AUD is not even
close. There is clearly a deceleration going on. The fears of a slowing economy are real.”

Economists are currently forecasting about 3.5 percent real GDP growth for Australia through mid-2005, which would be down from the second quarter 2004 year-over-year 4.1 percent pace.
In recent market action, Rogers notes, “the Asian accounts have been selling into it rather than buying it. The AUD has been struggling to get above 0.7390.”

Rogers recommends traders look to sell the AUD on the crosses, such as the euro, the yen or the Swiss franc. Though, he adds, “selling it against the U.S. dollar would be tough because we are in a broadly declining dollar environment.”

The Reserve Bank of New Zealand (RBNZ) has been on a tear this year, hiking interest rates five
times as of mid-October. Analysts say another .25 basis point rate hike is likely in the cards at the Oct.
28 meeting. If that materializes, it would push the official cash rate there to a whopping 6.50 percent
the highest in the industrialized world.

This aggressive monetary tightening helped the New Zealand dollar (NZD) be one of the strongest currencies against the U.S. dollar in the third quarter. The NZD has rallied from its 2004 low, hit in late May at 0.5912, to near the 0.6950 area in late OctoberBut the fast pace of tightening by the RBNZ could actually backfire and weaken sentiment for the NZD looking ahead. Fears that the RBNZ overtightened, which could actually weigh on economic growth in New Zealand, could depress the currency.

“They may have to pull a Bank of Canada and cut rates in the first quarter of 2005,” says Tom Rogers, senior currency strategist at Thomson Financial. (The Bank of Canada abruptly shifted
gears in its monetary stance mid-year in 2004.)

“The RBNZ has been hiking in a slowly growing global environment and we all know that everything is interrelated,” he adds. Slower growth forecasts for the country have already been issued by the RBNZ, with GDP seen at a 2.5 percent year-over-year rate in the first quarter 2005, vs. second quarter 2004’s
strong 4.4 percent year-over-year pace. Sean Callow, currency strategist at Ideaglobal, echoes Roger’s concerns.

“They might have been too aggressive on their rate hikes,” he says. “While their economy is doing well, they need to be paying more attention to the global economy.”

In addition to concerns over sustaining economic growth amid the tight monetary policy atmosphere, the NZD is hurtling straight toward major psychological and chart resistance at the 0.7100 level, the February 2004 price peak.

“The 0.7000 area is a tough barrier,” says Callow. “Psychologically, that means a lot to the Kiwis. They are worried about their competitiveness at that level. They are very reliant on selling their products to the world and they don’t want to be burdened by a high exchange rate.”

Just this year, New Zealand passed legislation permitting the RBNZ to intervene if the exchange rate is exceptionally high or low. As the NZD approached that 0.7000 level in late October, the New Zealand Finance Minister made statements suggesting the administration was not “comfortable” with the level of the NZD. Speculation of intervention if the NZD moves above the 0.7000 level could provide the currency with a tough ceiling.

“I wouldn’t be buying it here at 0.6900,” says Callow. “At these levels, I’d be leery of coming in and chasing the market higher,” agrees David Solin, partner at FX Analytics.

Some analysts say risks exist for a correction or at least a slowdown in the bull trend. David Solin, partner at FX Analytics, notes since January 2002 “USD/CAD has come from the $1.60s to $1.24 in the space of two years.” Can the trend continue? “Not at this pace,” warns Solin. “We are getting very long in the tooth.”

Analysts agree that, at a minimum, there is room for a healthy correction in USD/CAD. Overall, the decline in USD/CAD has been very orderly in recent months and price has retreated within a well-defined downtrend channel on the daily chart. “At some point, we will need a little bit of a shakeout and a dollar rally,” says Coleman.

Traders should anticipate bearish risks such as a sharp pullback in crude oil prices, which could spark a retreat in the Canadian dollar, or an overall shift in bearish U.S. dollar sentiment. Also, there is that high number of speculative traders holding long positions. COT data is typically used in a contrarian fashion, with individual speculators representing the leastinformed and most underfinanced sector
of the trading community. As such, they are prone to rush in at highs and sell at lows. The fact that most of them are long now is an argument in favor of a correction.

Nonetheless, barring any major unexpected events, such as a terrorist attack or a radical shift in Bank of Canada monetary policy, “we are still in a ‘sell the rallies’ mode for USD/CAD,” says Coleman. Traders could look to monitor action within that downtrend channel and “lighten up as we near the bottom of the channel and take advantage of corrections to re-establish shorts.”

Solin agrees forex traders would be best served by shifting to a range-trading strategy as he expected “range-y” market conditions ahead.

Since late May, the U.S. dollar/ Canadian dollar currency pair (USD/CAD) has trended solidly lower,
falling from the $1.40 area to the $1.24 level, signaling a significant strengthening in the Canadian currency. The reason is simple: Overall, the Canadian economy has performed better in 2004 than most economists expected. Exports grew beyond initial forecasts, which supported GDP growth, while inflation levels remained low.

After posting economic underperformance vs. the U.S. dollar a year ago, some analysts now expect Canada to outperform in 2005. The Bank of Canada recently issued a revised growth forecast for 2005, putting GDP growth just under the 3.0 percent mark, which could compare favorably to forecasts for 2.5 percent GDP growth in the U.S. next year.

But beyond that, a number of other bullish factors have supported the gains in the Canadian currency, including a strong trade surplus (in part helped out by higher crude oil prices) and aggressive tightening by the Bank of Canada. However, some wonder how much stronger the CAD can get.

“Canada has a compelling fundamental story…but an awful lot of good news is already factored into the price,” notes Jamie Coleman, managing analyst at IFR/Forex Watch.

After three rate cuts early in the year, the Bank of Canada shifted gears this summer, from an easing stance to a tightening stance. The central bank hiked rates in September and October, boosting the overnight cash rate to 2.50 percent. In its latest statement, the Bank of Canada suggested additional rate hikes could be expected.

An expanding trade surplus, compared with the U.S.’s widening trade deficit, is also another factor in the bullish camp in recent months, analysts say.

“[Canada] already had a trade surplus, but [has] gotten an extra boost from rising commodity prices in general,” says Sean Callow, currency strategist at Ideaglobal.

Canada’s merchandise trade surplus stood at $CD7.4 billion in August, up from year ago levels at $CD4.9 billion. “They are an oil exporter,” explains Dave Sloan, senior economist at 4Cast Inc. “When oil is strong that is a boost to their growth.”

And oil is indeed strong. New York crude oil prices recently hit a new record level at $55 per barrel before pulling back to around $50 at the beginning of November. Adding power to the overall bull
trend in the Canadian dollar is the speculator buying.

“This is a favored speculative trade,” says Callow. “It’s a very liquid market and nobody is fiddling with it. If someone wants to sell the U.S. dollar, you can’t buy China because it’s fixed. With Japan you might have intervention, but with Canada nobody is going to stop you on the other side of the trade.”

Recent data from the Commitment of Traders (COT) report, released by the Commodity Futures Trading Commission (CFTC), backs this up.

The COT report shows the net positions of different classes of traders. Speculators were long 66,500
Canadian dollar futures contracts, the third largest total since October 1992, according to Callow.

Into 2006, while the U.S. Fed is expected to ratchet up the Fed funds rate a few more times, most analysts acknowledge the U.S. tightening cycle is nearing an end. The persistent and consistent rate hikes in the U.S. have been a main factor supporting the U.S. dollar, especially vs. the Euro, throughout 2005.

Once it becomes clear the Fed is done with its tightening cycle, analysts say the opportunity may exist for a turning point in market sentiment and market focus. In fact, forex players may become more focused on structural problems within the U.S., including the giant current account deficit, which could draw money flows away from the greenback.

That in turn, could open the door for Euro strength, some analysts say.

Ideaglobal’s Powell sees potential for the Euro to return to the $1.2200 zone by the end of first half 2006.

Thomson’s Coleman points to a key resistance area at $1.1865 in the Euro/U.S. dollar (EUR/USD) rate. As long as that resistance ceiling remains in place, he expects additional downside pressure on the Euro in the days and weeks ahead.

On the downside, he highlights $1.1590 as potential support. That level represents a roughly 38.2 percent retracement of the lifetime range of the Euro from .8230-$1.3665, he says. Declines under $1.1590 would open the door to the $1.1450 region.

David Powell, currency analyst at Ideaglobal, says the “market is pricing in a 40-percent chance of a 2.75-percent rate by March.” The ECB is set to meet next on Jan. 12.

But, given the overall sluggish growth forecasts for the Eurozone into 2006 and the still negative interest-rate differential vs. the U.S., analysts are not turning wildly bullish on the European currency. In fact, some still see room for additional downside in the Euro in the weeks ahead, especially given the ECB’s mixed message that any future tightening could be “moderate.”

The ECB is in a difficult position as it has a mandate for price stability, yet growth numbers emerging from the Eurozone remain extremely lackluster and sluggish. Eurozone headline inflation has been steadily above the 2-percent target — 2.5 percent in October and 2.6 percent in September.

Eurozone Finance Ministers have been speaking publicly against the need for a rate hike by the ECB because they feel it would not help the slow-growth scenario that continues to unfold there. As of mid November, the European Commission was forecasting gross domestic product (GDP) growth of 1.3 percent for 2005.

“The Eurozone is slowly recovering from pretty poor performance in the first half of the year,” said Charmaine Buskas, an economist at Economy.com, ahead of Trichet’s Nov. 18 comments. “This is a conundrum for the ECB. Do they act to protect their price stability to keep it in line with their mandate or do they stand aside and allow growth to unfold organically?”

Trichet appeared to be keenly aware of the political pressures from Eurozone Finance Ministers. Trichet noted the ECB would “maintain moderation and accommodation and the policy would remain accommodative.”

“This is the worst piece of central banking I’ve ever seen,” says Thomson’s Coleman. “He says we are going to hike, but not by much. To downplay the impact of hikes before they even start hiking takes away some of their credibility.”

After months of hawkish talk, European Central Bank (ECB) President Jean-Claude Trichet let the cat out of the bag on Nov. 18.

“After two and a half years of maintaining historically and exceptionally low interest rates...the governing council is ready to make a decision,” Trichet said at a Frankfurt European banking conference on Nov. 18.

The market and most currency analysts interpreted this as a clear sign an initial hike will occur at the Dec. 1 policy meeting, with additional rate hikes following in 2006.

With higher energy prices pushing headline inflation to uncomfortable levels for the inflation conscious ECB, officials have been warning for months that a rate hike may be in the cards.

But ahead of the unexpected Nov. 18 comments by Trichet, most analysts had expected the ECB to wait until early 2006 to make their first policy move. The ECB has kept its key refinancing policy rate unchanged at 2 percent since June 2003.

“The comments were a surprise — they came out of the blue,” says Jamie Coleman, managing director at Thomson Financial IFR. While these comments “practically cement” a .25 basis point rate hike at the early December meeting, he says, the question for currency traders is how much more tightening can be expected — and can it reverse the recent weakness seen in the Euro/U.S. dollar?

Several economists warned that forex market focus could shift back to the bearish fundamental and structural situation seen in the U.S., which could weigh on the dollar.

“It is important for investors not to get too swayed by short-term trends in the currency markets,” Harris says. “There still is a fundamental imbalance in global economic affairs.”

He points to the current account deficit, which was likely to hit $700 or $800 billion on a yearly basis in 2006.

“Investors will start to question the huge borrowing requirements the U.S. has,” Harris says. He calls this a “chronic risk” to the currency.

Kasriel agrees that forex traders could shift their focus back to this larger issue in 2006.

“Global investors are going to start to wonder just how the U.S. intends to pay interest and dividends on all this capital it is importing,” he says.

At this time last year, many forex analysts and traders were fixated on the U.S. twin deficits (domestic and foreign) and how they would pressure the greenback in 2005. However, forex traders quickly shifted their focus to the more bullish Fed story earlier this year.

Market watchers voice concern that an end to Fed rate hikes in the U.S. could weigh on the overall dollar outlook into 2006.

“While the Fed is nearing the end of its tightening cycle, there could be other central banks that are going to enter tightening cycles,” Kasriel says.

That could spell a narrowing of the positive interest rate differentials that have recently been in the dollar’s favor. Kasriel believes the ECB, the Bank of Japan, and possibly even the Bank of England could potentially tighten rates in 2006.

“The dollar might have some rate competition from abroad,” he says. “I think the dollar will be weaker next year.”

Lehman’s Harris agrees. Into the first quarter, Harris sees potential for the dollar to remain strong “until investors see the Fed moving to the sidelines,” he says.

“Sentiment around the dollar should shift and the market should resume its longer-term decline.”

Harris and Kasriel both think the 2005 rally in the dollar is a shorter-term correction in the overriding longer term bearish trend. Harris sees potential for a 10-percent drop in 2006.

Most economists agree the spike in energy prices is the main culprit behind the recent surge in headline inflation data in the U.S. The Consumer Price Index (CPI) hit a 14- year high at 4.7 percent in September. However, the core rate (which excludes food and energy) for the month posted a more moderate reading of 1.9 percent.

“Almost nothing outside of energy looks that threatening,” notes Lehman’s Harris.

What economists and the Fed will be watching for in the coming months, however, are signs that higher energy costs are being passed along as price increases in other areas of the economy.

Consumers have already seen some relief on the energy front as of mid-November, as both gasoline and natural gas prices had retreated off their September and October highs, which could bode well for inflation numbers into the New Year.

“Energy prices are unlikely to spike a lot higher,”
Kasriel says. “You’ll see inflation moderate going forward.”