Still short Usd - but looking for a comeback

A very sharp drop for the Usd over the last two weeks have shifted market sentiment substantially against it. "The Usd rally has peaked", given the fiscal issues and interestrate differentials, the Usd will only go weaker from here, seems to have been the main argument.

While I do not disagree that fiscal issues and interest rate differentials play a role, I believe there are some other factors that must be looked at before saying the Usd rally is over.
In fact, I do not believe it is.

This December move has had more to do with general Euro strength. Other "high yielders" like Aud and Gbp have lagged vs the Usd.
If the Us fiscal issues would have been the cause of the move, we should have seen the CDS on US Treasuries rise sharply. We havent.

I suggest we look to the CEE area instead, where we have seen the Euro rise sharply vs certain CEE currencies. The CEE situation is becoming rather precarious and will weigh heavy on the European banks. As we have been running up towards year end there have beeen strong incentives for them to reduce overseas exposure and shore up their balance sheets. Hence repatriation flows into the Euro are taking place, with the low market liquidity exaggerating the move.

So for the rest of this year, repatriation flows and the widening yield differential could propel Eur/Usd further up towards the 1.47/1.50 area.

Going into 2009, I am tempted to become Usd bullish again.
Why is that then?

Well, fine, we all know that households, banks and corporates are all under pressure globally, consolidating their balance sheets. With the US being a net liability holder, this process is normally interpreted as working against the USD.
I dont necessarily buy into this at this stage.

With foreign investors mainly invested in (the relatively safe) US denominated debt. US based investors have their main foreign investments in (the relatively less safe) stock and high yielding bondmarkets.

However, with QE(Quantitative Easing) in place and US authorities aiming to bring credit spreads down, foreign investors in the US holding corporate and agency paper will benefit.
Since 25% ish of agency and corporate bonds in the US are held by foreign accounts,
getting the spreads to tighten will only happen if they remain committed to their investments.
A falling Usd does not work in this context.
Hence, as long as credit remains the main policy variable for the US authorities, they will have no incentive to weaken the USD. Quite the opposite.

If one expects the US to be the first country to rebound out of the current recession/depression and that this will happen during 1h 2009, yield differentials will move into the USD´s favour. With Euroland still behind the curve and most likely to do too much too late, starting early next year, there is a strong case for a lower Eur/Usd right there.

However, before the yield differentials move into the Usd´s favour and consensus starts shifting about the Usd direction, Eur/Usd will likely have fallen quite a good distance already.

I believe the more proactive and focused policy responses seen in the US compared to the slower and traditional policy response seen in Europe should keep the US asset markets relatively attractive to global investors and provide support for the USD.

Net net; For the remainder of this year, I do not rule out Eur/Usd touching 1.50. I am still short Usd and will keep a very pragmatic negative bias for now.
Going into 2009 I will look for evidence to position myself long Usd, looking for a move sub 2008 lows at 1.2330 within the first couple of months of 2009.

As always,
Good luck







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