Three Forex Predictions for 2012

Currency traders in 2011 saw immense volatility in the markets, as global uncertainty and sustained central bank intervention lead to a number of shakeups. Although the future is uncertain, conditions appear to be setting up for another wild year in 2012. Here are three predictions on possible events that could change the face of the currency markets tremendously in 2012:

While European politicians have done their best to keep the Eurozone in tact thus far, the Eurozone enters the year with continued uncertainty over its future. High profile summits in October and December failed to produce anything definitive, while the region has continued to muddle along. Although Italy and Greece have had their leaders basically replaced with Eurozone-appointed technocrats, their financial situation has failed to improve. Greece may not be seeing the violent demonstrations it saw during the summer, but it has consistently failed to achieve budget targets. The legality of its 50% voluntary haircut plan remains in doubt. If some (or even all) of the weaker Eurozone countries were to exit the Eurozone, it would have a tremendous affect on the value of the euro. While the euro could initially trade lower due to uncertainty, in the end, the currency may be stronger for it. Rumblings of a proposed "two-tract" Eurozone have hung around the markets for most of the fall. Predictably, euro politicians have openly rejected the notion, but if the weaker countries were to exit, the situation would essentially be forced. A new Eurozone composed primarily of the stronger,"core" members would theoretically be able to approach financial and monetary policy in a more aggressive manner. That could mean a stronger euro in 2012, even if the path to that strength is extremely bumpy.

US policy makers on both sides of the aisle have begun to intensify their rhetoric on China's currency policy—specifically its peg. It makes sense from a political perspective. If China were to strength the value of the yuan relative to the US dollar, it should presumably drive down the trade deficit the US has with China and create demand for manufacturing jobs in the US. However, China is currently undergoing an immense slowdown. Despite China's recent move to shift gears and begin easing again, the Shanghai Composite has fallen tremendously—down nearly 15% in the last month alone. Should China's slowdown accelerate into a full-fledged crash, the People's Bank of China could opt to revise its peg—but downward. The PBOC, in the face of China's slowdown, is much more likely to weaken the yuan than it is to strengthen it.

After wrapping up QE2 in June, the Fed was relatively subdued for most of 2011. Operation Twist and the Fed's promise of prolonged low rates appear to have had a much weaker affect than the implementation of QE2. If the euro continues to feel pressure in 2012, and China moves to weaken the yuan against the dollar, the Fed could come in with QE3. Although the Fed maintains that QE is unrelated to the dollar's relative trading value, many currency commentators disagree. There exists a significant segment of commentators who argue that the entire purpose behind QE policies is to weaken the dollar for the purposes of boosting employment and lessening the relative debt load of the US government. If the dollar shows strength early in 2012, traders may expect the Fed to react with QE3 in the second half of the year.