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US Dollar Index Ends 2008 Up 7% Following Year of Record High Volatility and the Collapse of Modern Finance

Wednesday, 31 December 2008 20:30:12 GMT  |  Terri Belkas, Currency Strategist

- Euro Ends Year Down Slightly Against US Dollar as EUR/GBP Dictates Price Action 
- Japanese Yen Ends Wednesday Mixed, Finishes 2008 as Biggest Gainer of the Year

US Dollar Index Ends 2008 Up 7% Following A Year of Record High Volatility and the Collapse of Modern Finance
On the final day of 2008, the US dollar index wrapped up the year up 6.72 percent as risk aversion drove the currency higher for much of the second half of the year amidst historically high volatility. In reality, this does not even begin to tell the story of 2008, and how modern finance as we knew it collapsed with the bankruptcy of Lehman Brothers, the takeovers of Bear Stearns by JPMorgan Chase and Merrill Lynch by Bank of America, and the transformation of the last two standing investment banks - Goldman Sachs and Morgan Stanley - into bank holding companies. The decline of the banking sector was the direct result of an all-consuming increase in risk aversion, fear, and ultimately, interest rate spreads. So why did the US dollar gain 24 percent between mid-July and November? Treasuries and the US dollar became the safe-havens of choice, and funds flowed en masse toward these assets as the CBOE’s VIX Volatility Index climbed from about 20 in July to a record high of 89.53 on October 24, beating out the highs reached following the collapse of LTCM in 1998 and after the terrorist attacks on September 11, 2001.

Stock market volatility has since died down, as evidenced by the first decline in the CBOE’s VIX index below 40 since October, but forex market volatility, as measured by the DailyFX VIX index, remains near record highs. The implications of this became clear today as lower liquidity helped to exacerbate choppy price action in the EUR/USD and GBP/USD pairs. This actually had more to do with extreme movements in EUR/GBP, which will be discussed below. Meanwhile, the greenback ended the day up less than 1 percent against the euro, Japanese yen, and Swiss franc, but tumbled versus the British pound (-1.3 percent ), New Zealand dollar (-1.5 percent), and Australian dollar (-2.33 percent). US economic news had little to do with the moves, and the commodity currencies had the more than 10 percent surge in oil prices to thank for their gains.

Looking at the US data on hand, US initial jobless claims initially appeared rather optimistic as they fell 94,000 to 492,000 during the week ended December 27. However, these numbers are actually skewed because of the shortened holiday week and for what it's worth, employment reports for the last two weeks of December should be ignored for this reason. Indeed, the surge in continuing jobless claims for the week ended December 20 provides a more accurate view of the US labor markets, as they rose to a fresh 26-year high of 4,506,000. Looking back at historical data, the steady climb in claims for unemployment benefits logically suggests that the unemployment rate for December will likewise jump upon release on January 9. The markets will be closed on January 1, but on Friday, the Institute for Supply Management’s (ISM) index of manufacturing conditions will hit the wires. The index for the month of December may fall to the lowest levels since 1982, while the record low of 29.4 from May 1980 looms close below. Overall, the report may only impact the US dollar if it is surprisingly optimistic, as the Federal Reserve has already cut the fed funds rate to a record low range of 0.0 - 0.25 percent from a six-year high of 5.25 percent in September 2007 and has no room for maneuver from a traditional monetary policy perspective.

Related Article: Top Forex Trades for 2009

Euro Ends Year Down Slightly Against US Dollar as EUR/GBP Dictates Price Action
In the final days of 2008, EUR/GBP traded at record highs to target parity, as the markets anticipated that the European Central Bank would be far slower to cut interest rates than the Bank of England. The plunge in the British pound against the euro has resonated throughout the forex markets, as evidenced by the end-of-year stats. In fact, the euro only lost about 4.3 percent against the US dollar during 2008, while the British pound plummeted 26.5 percent. Both currencies started to fall sharply in July, but emerging weakness in the US dollar following the Fed’s surprisingly aggressive rate cut in December did not translate into GBP/USD strength, unlike the EUR/USD, which recouped roughly half its losses from mid-year. Going into 2009, it will be interesting to see if a pick up in liquidity will lead US dollar trends to become dominant once again, or if the choppy ascent of EUR/GBP will remain in the driver’s seat until the pair hits parity. This is something that will be reassessed on Friday.

Related Articles: Euro/US Dollar Exchange Rate Forecast, British Pound/US Dollar Exchange Rate Forecast

Japanese Yen Ends Wednesday Mixed, Finishes 2008 as Biggest Gainer of the Year
The Japanese yen ended Wednesday mixed across the majors, as the currency fell nearly 2 percent against the Australian dollar and British pound, but gained slightly against the euro and Swiss franc. This price action marked more of a consolidation in the Japanese yen crosses and less of a clear directional move, but speculation that Japan will attempt to intervene in the currency markets in the near-term has faded. Overall, the Japanese yen has finished the year as the strongest major currency, but with risk appetite showing a few signs of improvement, such as the first drop in the CBOE’s VIX Index below 40 since October, the yen could pull back further. As I mentioned in my own forex trading pick for 2009, I think that risky assets like the Japanese yen crosses could gain at the start of the year, but I also believe that risk aversion will make a comeback in late Q1 or Q2, which may present good selling opportunities for these currency pairs. Best of luck in trading during 2009, and Happy New Year!

Related Article: US Dollar/Japanese Yen Exchange Rate Forecast

**For a full list of upcoming event risk and past releases, go to the DailyFX Calendar




Written by Terri Belkas, Currency Strategist of DailyFX.com
E-mail: tbelkas@dailyfx.com

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