EURO-DOLLAR ENTERED FINAL ACCELERATION OF BEAR MOVE

Widespread fears about the severity of fiscal consolidation in the Euro zone and its impact upon the European recovery are hurting the Euro but the European currency’s down trend has already transited from a mature stage into the final acceleration phase that heralds a selling climax ahead.

We advise vigilance and avoiding complacency as the market’s nearly unanimous bearish view is accompanied by massive amounts of short Euro positions that can make it vulnerable to reversal shocks.

After the unprecedented set of measures that has stabilized vulnerable sovereign markets in Greece, Portugal, Spain, Italy and Ireland, European leaders are attempting an ambitious initiative that may offer the Euro zone a comprehensive set of rules and policies that will transform its economic governance and offer instruments for a more effective management of fiscal policies. The current perception of deep seated structural budget coordination problems that afflicts the Euro can therefore be subject to a significant reassessment by markets, were the currently debated initiatives lead to substantial and rapid decisions involving a credible set of new policies strengthening European fiscal coordination.

The impact of fiscal consolidation in the countries with excessive deficits can not be dismissed but little consideration is currently given to the fact that Greece, Spain, Portugal and Ireland together contribute less than 20% to the Euro area GDP.

Little attention is given at present to the prospect of a stronger than expected recovery in Germany and other key European countries, as suggested by the substantial recovery in their leading diffusion indices.
Evidence of a better than currently feared recovery can move market expectations over coming months.

If developments on the European fiscal front translate into meaningful improvements in European economic governance and European growth proves stronger than currently feared, market expectations can eventually realize that Europe is a better risk presently assessed. Britain and the United States show deficits far exceeding the European average and debt levels are at rising faster than in the Euro zone aggregate.

On the interest rate front, the perception that European rates will stay low for an extended period is correct. We clearly believe however that market expectations of an earlier tightening in the United States neglects the fact that the US, whose strategy for fiscal consolidation is essentially only based on a strong economic recovery, will also need to maintain interest rates as low as possible for as long as possible.

Core inflation in the United States remaining around 1.0% until at least late 2011 will make it possible to keep an accommodating monetary stance for longer then currently assumed by the market.

The current perception of the liquidity issues on the exchange rate is also subject to evolution. The market may be overestimating the extent of liquidity creation in Europe. Limited purchases of European debt by the ECB have rapidly stabilized vulnerable sovereign market and reduced spreads. There are yet no clear indications as to the extent of additional funding supplied by the ECB to the banking system but its amount may also be limited. Moreover the ECB can move to sterilize these injections when it deems suitable.

What ultimately seems to attract little attention is the fact that the current appetite for Dollars is basically financed by the reopening of the swap agreements between the Federal Reserve and other Central Banks. ECB injections of liquidity in the market is essentially funded by Dollar swaps. Moreover, if a disorderly fall in the euro continues the ECB may choose to surprise markets by intervention in the foreign exchange markets.

While at the time of writing bearish momentum on the Euro is still unchecked, our long term monitors indicate that the EUR-USD has already moved from a mature stage into the terminal acceleration which is likely to precede a major bottom for the Euro. (See Forecast EUR-USD Long Term).