US dollar fell for a second year against other major currencies. After declining some 8% versus a basket of currencies in 2006, the greenback has dropped about 9% since the start of 2007.

Dollar weakness was particularly evident in the second half of the year, when the US housing downturn began to spread to the broader credit market and banks became unwilling to lend to one another. The problem started at the US subprime mortgage sector. With more subprime borrowers defaulting on their loans, credit ratings on debts backed by subprime mortgages were downgraded and more financial institutions had to write down the value of their debt derivatives portfolios. The crisis of confidence led to a credit crunch and central banks across the globe not only had to inject liquidity to ease the situation, but had to reverse their previously hawkish policy stance for fear of plunging the global economy into recession.

The US Fed, for instance, was widely expected to hold interest rates unchanged for the rest of the year before the crisis struck. But it has now cut rates three times, bringing the fed funds target rate to its present level at 4.25%. The European Central Bank also had to keep rates on hold rather than adhering to its preferred strategy of hiking rates.

In effect, the US subprime and credit crisis had two major impacts on the currency market. Firstly, the Fed's action to cut rates eroded the dollar's yield advantage, sending it to record lows against the euro and Canadian dollar, to within sight of the 1.50 and near 0.90 respectively in November. The dollar also plunged to 26-year and 23-year troughs of 2.1162 and 0.9400 versus the British pound and Australian dollar respectively.

In addition, concerns about a credit meltdown also sent risk averse investors looking for cover, leading to mass unwinding of carry trades after the summer. The Japanese yen and Swiss franc, with their relatively low interest rates, are popular funding currencies for carry trades, surged against other high yielders such as the Australian and New Zealand dollars.

What will happen in 2008, will dollar weakness persist? The answer really depends on what happens in the credit space. Central banks and government officials everywhere are doing all they can to ease the credit crunch. US President Bush has unveiled a plan to help struggling American homeowners to avoid foreclosures, while US Treasury Secretary Henry Paulson is pushing for the setting up of a superfund to absorb banks' credit derivatives which are eroding in value. Further interest rate cuts are also on central banks' agenda.

Nevertheless, it takes time for these efforts to work. It will also take time for the US housing market to work off its inventory overhang. While the US economy may be able to muddle through, a sharp slowdown is inevitable.

With the Fed expected to further cut interest rates, possibly to as low as 3.5% by the end of Q1 2008, while the ECB likely to remain on hold for an extended period, interest rate differentials will move against the US dollar, putting it under further downward pressure. The single currency could strengthen beyond the record 1.50 level sometime in the first quarter. The Japanese yen and Swiss franc could also gain against other majors as investors trim their exposure to risk and unwind carry trades. But as liquidity conditions improve, these trends could be reversed in the second half of 2008.

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