Introduction
Hello. My name is Collin Crownover.  Welcome to SSgA's review of foreign exchange markets for the fourth quarter of 2007.

4th Quarter Recap
Central banks confronted multiple challenges in the fourth quarter, including the slowdown in global economic growth, rising inflation rates, illiquid market conditions and the risk of an accelerating credit crunch.

Central Bank Actions
In response to the slowdown in growth, the Federal Reserve, Bank of England and Bank of Canada cut short-term rates. The Fed reduced the Fed funds rate by 50 basis points during the quarter, while the Bank of England and Bank of Canada both reduced rates by 25 basis points.  Most other central banks remained on hold, including the European Central Bank and the Bank of Japan, while the Norges Bank, Riksbank and Reserve Bank of Australia each increased short-term rates by 25 basis points.

Response to Deterioration in Market Liquidity
Central banks also responded to the deterioration in market liquidity. The spread between short-term inter-bank interest rates – such as LIBOR – and overnight rates rose to several times historical averages, due to the uncertainty associated with the credit quality of numerous financial institutions. For example, the differential between LIBOR and the Fed funds rates rose to 75 basis points, versus a normal level between 25 and 30 basis points.  On December 12th, the day after the Federal Open Market Committee meeting, central banks, in the US, Eurozone, England and Canada, announced coordinated action designed to enhance the availability of liquidity.  These initiatives were designed to reduce the risks of a severe credit crunch.  They underscored central banks' commitment to ensuring that shortfalls in liquidity do not imperil economic or financial stability.

Volatility
Volatility fluctuated throughout the quarter. For example, the VIX rose sharply from 18.53 on October 31st to 31.09 on November 12th, before declining to end the quarter at 22.50.¹ Currency carry trades (long positions in high yield currencies funded through short positions in currencies with low yields) were slightly positive in October, but declined sharply as the VIX rose between October 31st and November 12th. Oil prices rose from $81.66 to close the quarter at $95.98.²  The dollar index – or DXY – depreciated by 1.4% in the fourth quarter versus other developed market currencies, especially relative to the Euro and the low-yielding Swiss franc and Japanese yen.³ The DXY declined by 8.3% in 2007 and has fallen by close to 40% since 2002.⁴ The commodity-linked Canadian and Australian dollars were the strongest performing developed market currencies in 2008, appreciating by more than 10% versus the USD.⁵

United States
The headwinds of rising energy prices, continued fall-out from residential real estate, tighter credit conditions and declining stock prices likely contributed to a significant slowdown in GDP growth in the fourth quarter. The Federal Reserve reduced short-term interest rates by 50 basis points to 4.25%, despite signs that inflationary pressures remained above Fed targets. Year-end core PCE inflation rose by 2.9% over the previous three months and by 2.2% over the past year.⁶

Fed Launches Term Auction Facility
In response to market liquidity, the Federal Reserve in December launched the Term Auction Facility to provide increased access to liquidity. This initiative, part of a broader set of policies enacted by a number of central banks, reduced LIBOR spreads over the Fed funds rate from 70 to 45 basis points.⁷ However, the increased availability of liquidity has not resolved underlying tensions associated with credit market valuations.   The Fed is widely expected to reduce interest rates when it meets on January 30th.

Canada
The Canadian dollar continued to strengthen in October reaching a multi-decade high of $0.92 versus the US dollar on November 6th.⁸ During the first half of the quarter, rising oil prices, continued M&A flows and strong retail sales supported the Canadian currency. Thereafter, the sharp decline in oil prices led to a reversal of these gains and the currency ended the quarter close to parity with the USD.

Bank of Canada Actions
The Bank of Canada reduced interest rates by 25 basis points when it met on December 5th in response to growing signs of an economic slowdown and plummeting inflation, which ended the quarter at 1.6%, below the Bank of Canada target.⁹ Market participants have priced in a 50% likelihood that the bank reduces interest rates when it meets on January 22nd.¹⁰

Eurozone
The Euro peaked at a record level $1.4873 on November 26th.¹¹ The European Central Bank – or ECB – remained on hold throughout the fourth quarter, as inflation, led by food and energy prices, accelerated from 2.1% in September to 3.1% at year-end.¹²

ECB Actions
The bank has remained “hawkish” relative to other central banks while articulating a clear distinction between measures designed to assist market liquidity versus those intended to affect overnight interest rates. As noted earlier, the ECB participated in the coordinated action in early December, designed to reduce interest rates charged on inter-bank loans, providing a sizable 346.8 billion euros, equivalent to about 500 billion US dollars.¹³

With the ECB so far standing firm in its unwillingness to reduce short-term rates, the Euro strengthened during the fourth quarter and ended the year at $1.4621 versus the US Dollar.¹⁴ At quarter-end, markets had priced in an increase in short-term rates in Q1 08.¹⁵

United Kingdom
In the UK, growing concerns about the housing market resulted in a unanimous vote by the Bank of England – or BOE – in December to reduce rates by 25 basis points, following two previous divided votes to remain on hold. The comments in the Financial Stability Report released on October 25th, expressed concern that the credit market deterioration was not yet over and could spread to other parts of the housing market.¹⁶

Bank of England Actions
The BOE action in December came despite rising inflationary pressures, which at 2.1% were slightly above the 2% target ceiling.¹⁷ Further rate reductions appear likely in 2008. The BOE is focused on the slowdown in growth and the deterioration in credit conditions. The British pound appreciated by only 1.7% versus the US dollar in 2007.¹⁸

Other European Countries
Other central banks in Europe, including the Riksbank in Sweden and the Norges Bank in Norway, increased interest rates by 25 basis points during the quarter while the Swiss National Bank remained on hold, given reduced inflationary pressures.

Japan
The Bank of Japan – or BOJ – remained on hold in the fourth quarter. For the first time in ten months, core CPI on a year-over-year basis was positive in October, at 0.1%.¹⁹ During the first half of the quarter, the BOJ indicated that it retained a tightening bias, despite global financial market uncertainties.

Japanese Economy Slowing
However, data released toward quarter-end indicated that the Japanese economy was slowing once again. Housing starts plummeted and construction orders fell due to stricter rules on issuing building permits and the Nikkei index declined by 15% from its 2007 high.²⁰ The Tankan survey released in December also underscored weaker conditions due to rising costs and weak demand. The BOJ remains resolute that these conditions are temporary. The Japanese yen appreciated relative to the USD by 2.9% in the fourth quarter.²¹

Australia and New Zealand
Economic growth in Australia and New Zealand has remained relatively strong versus the rest of the developed world and inflationary pressures have accelerated in both economies. The Reserve Bank of Australia increased short-term rates by 25 basis points on November 7th, while the Reserve Bank of New Zealand remained on hold. Inflationary pressures have continued to remain strong in Australia and are likely to remain above the target ceiling of 2% to 3% in 2008. Both currencies appreciated by about 10% relative to the US dollar in 2008.²²

Conclusion
It appears that central banks recognize the seriousness of the situation in the credit markets and are responding in a flexible, albeit cautious manner. The combination of slow economic growth and rising inflationary pressures challenge the credibility of central banks. While risks of a global recession cannot be dismissed, if the slowdown in global markets persists, overnight rates will likely be reduced. A decision to focus on threats to growth rather than rising inflation will likely be pursued, given that declining growth will put downward pressure on inflation and rate cuts can be quickly taken back once the growth environment improves.

Finally, the US dollar has declined sharply relative to other developed market currencies over the past five years. While currency markets at times may tend to overshoot, there is an increasing probability that the US dollar recovers during the course of 2008.

Thank you.

¹  Bloomberg, January 4, 2007.
² Bloomberg, January 4, 2007.
³ Bloomberg, January 4, 2007.
⁴ Bloomberg, January 4, 2007.
⁵ Bloomberg, January 4, 2007.
⁶ J.P. Morgan Global Data Watch, December 7, 2007 – January 4, 2008.
⁷ Bloomberg, January 4, 2007.
⁸ Bloomberg, January 4, 2007.
⁹ J.P. Morgan Global Data Watch, December 7, 2007 – January 4, 2008.
¹⁰ Morgan Stanley, Market-Implied Central Bank Decisions, January 4, 2008.
¹¹ Bloomberg, January 4, 2007.
¹² J.P. Morgan Global Data Watch, December 7, 2007 – January 4, 2008.
¹³ J.P. Morgan Global Data Watch, December 7, 2007 – January 4, 2008.
¹⁴ Bloomberg, January 4, 2007.
¹⁵ Morgan Stanley, Market-Implied Central Bank Decisions, January 4, 2008.
¹⁶ UBS Investment Research, Foreign Exchange Note, December 28, 2007.
¹⁷ UBS Investment Research, Foreign Exchange Note, December 28, 2007.
¹⁸ The WM Company, 2007.
¹⁹ J.P. Morgan Global Data Watch, December 7, 2007 – January 4, 2008.
²⁰ UBS Investment Research, Foreign Exchange Note, December 28, 2007.
²¹ The WM Company, 2007.
²² The WM Company, 2007.

This material is for your private information.

The views expressed in this commentary are the views of Collin Crownover from SSgA's Global Currency Group through the period ended December 31, 2007 and are subject to change based on market and other conditions. The opinions expressed may differ from those of other SSgA investment groups that use different investment philosophies. The information we provide does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. We encourage you to consult your tax or financial advisor. All material has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy of, nor liability for, decisions based on such information. Past performance is no guarantee of future results.

SSgA may have or may seek investment management or other business relationships with companies discussed in this material or affiliates of those companies, such as their officers, directors and pension plans.

Posted On: January 31, 2008