FXIB Fourth Quarter and Yearly Review With 2011 Outlook

Foreign Exchange Market

Fourth Quarter Review
In our fourth quarter outlook we predicted that the market had overpriced in the US Federal Reserve Quantitative Easing program and that the US economic recovery would strengthen. The US economy did produce stronger growth this quarter and the US dollar did initially rally once the market knew what the Quantitative Easing program would consist of. Some important economic events we witnessed this quarter includes Ireland being bailed out by the EU, China hiking interest rates and reserve requirements, and commodities continuing to rally.

Yearly Review
The US dollar finished the year stronger against the Euro, at the start of 2010 the exchange rate traded around 1.43, and finishes the year at 1.3365. The primary driver for the US Dollar gaining against the Euro is the European Debt crisis making Euro denominated assets less appealing to investors.  The Yen also made significant gains against the US dollar  in which at the start of 2010 the exchange rate was at 92.50 and finishes the year at 81.00. This year saw the Yen at record levels against the major currency crosses. The  US dollar finished slightly stronger against the British Pound, in which the exchange rate started at 1.61 and finishes the year at 1.55. The following should come no surprise, but the Australian Dollar made significant gains against the US dollar, rallying from .90 to 1.0200. The Australian economy has been  strongly supported by this year’s rally in commodities and Chinese growth. The Swiss Franc finished stronger against the US Dollar due to its “safe haven” status amidst the European Debt crisis. The Swiss Franc started the year at 1.0300 and finishes at .9300. The US Dollar also finished weaker against the New Zealand Dollar, as the New Zealand Dollar rallied from .7250 to .7800.  Last but not least, the US Dollar fell against the Canadian Dollar as the exchange rate went from 1.0550 to finish the year at .9900. The reason for the US Dollar decline this year can be largely attributed to a slow recovery and the US Federal Reserves Quantitative Easing  program in which the market severely overpriced.

The 2010 Commodity Bubble
Commodities posted a record gain as adverse weather slashed global crops, debt woes in Europe boosted demand for precious metals as investment havens and China consumed more of everything from cotton to copper. The Thomson Reuters/Jefferies CRB Index of 19 raw materials jumped 29 percent in the last six months of 2010, the most since the gauge debuted in late 1956. Last month the gauge reached 333.67, the highest since Oct. 1, 2008. Cotton extended a rally to an all-time high, silver rose to a 30-year peak and coffee jumped to the highest since 1997. In 2010, commodity prices beat gains in stocks, bonds and the dollar as China led the recovery from the first global recession since World War II. Crops were ruined by Russia’s worst drought in at least a half century, flooding in Canada and parched fields in Kazakhstan, Europe and South America. Corn and soybeans recorded the biggest second-half increases in five decades. We at FXIB believe commodities are in a bubble and have been in a bubble since the third quarter of 2010. Recent economic reports from China are indicating that the Chinese economy is starting to slow down and this should start to take the steam out of commodities. We at FXIB are expecting the commodity bubble to deflate in the first half of 2011 as market prices become more aligned with fundamentals. The US economy has not recovered to pre-2008 levels but yet commodity prices set new record highs that exceeded 2008 levels.

Looking Ahead at the First Quarter and  2011

We have identified 11 potential risks for 2011 that we will be keeping an eye on:

Potential US Dollar pluses:

1. European sovereign debt crisis intensifies, driving European yields higher.
   
2. European Central Bank drops vow to remove stimulus; adds liquidity instead.
3. UK adds to Quantitative Easing to offset economic drag of fiscal austerity.
4. Chinese property bubble bursts.
5. US yields rise as US economic recovery gains strength.
6. US adopts comprehensive long-term fiscal program modeled after Simpson-Bowles Commission recommendations
7. USD retains and builds on reserve currency status as central banks shun euro and reduce existing holdings.
8. Geopolitical uncertainty in Iran, Korean Peninsula revive USD safe-haven status.
9. Bank of Japan, Bank of England, and European Central Bank embark on expansive new monetary easing, including Quantitative Easing.
   
10. Bank of Japan joins Asian neighbors in actively managing the JPY FX rate
11. Commodities bubble bursts as fear of dollar collapse abates.

Potential US Dollar Minuses

1. US and Japan join global sovereign debt crisis; gold and other metals benefit
2. US yields fall as US economic recovery flags; deflation fears revive
3. UK economy rebounds despite austerity; Bank of England raises rates to contain inflation
4. US yields soar as government fails to get a handle on fiscal policy and market loses confidence
5. Risk appetites rise, fueled by a rush of global central bank liquidity sending metals, agricultural products and energy sharply higher
6. Emerging markets continue to grow steadily, drawing capital from developed markets
7. JPY resumes climb versus USD and Asian currencies as Japan keep money at home rather than seek higher returns abroad
8. European sovereign debt crisis abates; banks replenish capital
9. China engineers a soft landing, restraining inflation without damaging asset markets
10. India overtakes China, becomes the market focus in emerging markets
11. Euro regains market confidence, dollar’s share of reserves declines