Buy the greenback and sell the Aussie dollar

The forex market promises to be a volatile trading ground this year. So, what will be the best bets in the months ahead?

In 2012, there "may be more forecasting of exchange rates, with less success, than almost any other economic variable", according to former Federal Reserve chairman Alan Greenspan. With that caveat in mind, here are some of the themes likely to dominate the forex market in the year ahead.

A good year for the dollar and yen

With the seemingly endless European crisis dominating sentiment, the key theme for currencies is whether investors are feeling generally optimistic in risk-on' mode or pessimistic, says Tom Lauricella in The Wall Street Journal. Europe's failure to come up with a lasting solution to the debt crisis, and the potential for further trouble, ensured that the euro finished 2011 as the worst-performing major currency, reaching a 12-month low of around $1.30.

With jitters over Europe hardly likely to fade soon, this trend is liable to endure. As the world's reserve currency, the dollar is "the ultimate source of liquidity", says Stewart Hall of the Royal Bank of Canada. So investors who need to raise cash quickly in times of trouble flock to it, as the December panic demonstrated.

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The dollar's credentials are also being bolstered by "a US economic growth dynamic [not evident] in Europe and Asia", says Hall. With global growth on the slide as Europe sinks into recession and export-dependent Asia slowing, risk appetite will be constrained, says investment bank Morgan Stanley. That points to a good year for risk-off' currencies, such as the dollar and the yen.

Fading growth in Europe also implies a fall in interest rates in the eurozone, which are higher than in America. As rates decline in Europe, the potential return on European assets falls too, undermining the euro's appeal. If the European Central Bank ends the fear of collapse via large-scale money printing or buying peripheral bonds, the extra supply of euros would also imply a weaker currency.

Put all this together and the dollar looks appealing, says Manoj Ladwa of ETX Capital, a derivatives trading firm. But the anti-euro trade is a crowded one: the Financial Times notes that hedge funds increased their bets against the single currency to record levels by the end of 2011. So short-covering rallies could prompt sharp counter-trend rallies in the euro's level against the dollar. Still, Standard Chartered bank sees scope for the euro to weaken by another 5% in the first half. Sterling, given Britain's growth prospects and its reliance on Europe, also looks vulnerable against the dollar.

The effect of China's slowdown

China's yuan may also be a major theme in 2012. Few expect a hard landing for the Chinese economy, but "where overheated property markets are concerned, there is no such thing as a soft landing", says Jeremy Warner in The Daily Telegraph. Is it likely that "a command economy can escape the usual laws of economics"?

Fears about the outlook are already prompting capital to leave China and putting selling pressure on the yuan. So, far from appreciating further, the currency may be devalued as the economic outlook darkens. That will inflame the ongoing trade spat with the US. But "if the Chinese have to choose between pleasing Washington and ensuring domestic stability, they'll go for the latter", says Wei Gu on

Ditch the Australian dollar

The slowdown in China, and the accompanying drop in demand for commodities, is especially bad news for risk-on' currencies typically driven by both the global growth outlook and commodities. This affects the Australian dollar, which is also beset by domestic troubles.

Unemployment is creeping up and the "historically over-leveraged balance sheet of the household sector" is also undermining consumption, says Further rate cuts are now on the cards. All this is "not a great scenario for the currency". Morgan Stanley sees it dropping by another 6% against the American dollar by September.