For the financial markets and the foreign exchange market in particular, 2007 was a year that gave everyone a much needed reality check. Over the past 6 years, the financial markets have become irrationally exuberant. Record low volatilities in the foreign exchange market sparked a vigorous appetite for risk, one that caused money market and state funds, which are suppose to be extremely conservative to be exposed to subprime risk. The hunt for yield and the belief that the good times would continue tempted many managers to look to increase their returns by investing in mortgage backed securities. The availability of cheap and easy money also led many mangers to leverage their bets which escalated their risk. Unfortunately the problems in the subprime sector blew up in 2007 and everyone learned the consequences of taking excess risk, the hard way. The lesson that money managers and investors learned in 2007 is to be more selective with their investments, be less exposed to risky assets and more conservative with leverage.
For the foreign exchange market, this will have a direct impact on carry trades. The primary reason why carry trades have thrived over the past few years is because volatility fell to a record low. They have now doubled from their June 2007 levels which means that carry trades will no longer be easy one way bets. The multi-decade highs that we have grown accustomed to will be much more difficult to achieve as everyone becomes more careful with their investments and strive not to repeat the mistakes made in 2007.
Also, with the US dollar falling to a record low against the Euro, currencies have become water cooler talk. The general public has become much more aware of how currencies can affect their daily way of life and this is a lesson that will remain with them for the foreseeable future.
Countries around the world and the financial markets have become much more intertwined, or in other words globalization has also been taken to another level this past year. Sovereign wealth funds have become a force to be reckoned with. Between the U.A.E, Singapore, Norway, Saudi Arabia, Kuwait and China, there are as much as $2 trillion to spend. Their shopping spree has led to some of the biggest deals this year with the latest being Singapore’s $4.4 billion investment into Merrill Lynch. Saudi Arabia also just announced that they are setting up their fund which is a big reason why we expect this trend to continue. As many of these government funds invest in US financial firms, it will help the US dollar and bring the world much closer together.