Before exploring the outlook for the US dollar in 2008, it is important to understand that decoupling in the global economy was a primary factor for the dollar’s weakness in 2007. As US growth slowed, growth in the rest of the world remained resilient thanks to the demand from countries like China, India and the Middle East.

When the US began to ease interest rates in August, many central banks in countries such like Australia continued to raise rates since growth was steady enough for them to focus on tackling inflation. In fact, up until the Bank of England’s and Bank of Canada’s interest rate cut in December, the US was the only central bank to cut interest rates in 2007. This decoupling of growth was one of the main factors that led to the out performance of the Euro, Australian, New Zealand and Canadian dollars, against the US dollar last year.

As we enter 2008, we are beginning to see recoupling in the global economy. In second half of last year, the expansion in the UK and Canada( Mortgage rates ) began to slow materially as economic data weakened, indicating that these countries were no longer resilient to weaker US growth. The ripple effects of the US subprime crisis has impacted many countries, especially the UK, who has relied on housing, finance and the public sector for growth over the past few years.

Chinks in the armor are also beginning to show in the Eurozone despite the central bank’s persistently hawkish monetary policy stance. If growth slows even further in the US or the other countries, the central banks that have been reluctant to ease rates last year may be forced to do so. The UK for example has already cut rates and they are expected to again in 2008. These are where the surprise elements lie for the currency market because the Federal Reserve has already cut interest rates by 100bp this past year.
Another rate cut from them will not be much of a surprise, but if the Eurozone begins to cut interest rates as well, it would mark a significant shift in monetary policy, which in turn could result in a major shift to the outlook for the currency.