Currencies: The buck stops here?

After several abortive rallies since the sub-prime crisis erupted last Summer, is the Dollar finally on the verge of a sustained rally? In hindsight I think the Fed's decision to hold the last rate cut to 75bps will be seen as a turning point in rate expectations. From these levels the growth/inflation trade-off is far more finally balanced that the FX market consensus assumes. Furthermore, although recent Eurozone data has been relatively strong, it is worrying that the spreads on bonds of the 'Club Med' countries such as Italy, Spain and Greece over German Bunds are now at their highest levels since the advent of EMU (between 50-60bps), reflecting bond market concerns for those economies which have a sub-prime property bubble and banking issue of their own (many property developers in Spain for instance have collapsed, Spanish banks are dependent on the ECB funding window for nearly all their lending) and fast rising debt/GDP ratios. Ireland is an honorary member of Club Med given its own world class property bubble and deteriorating fiscal position. Southern Europe is sliding quietly into recession and only the bond market seems to have noticed so far.

Although Germany has improved its global competitiveness steadily in recent years, and is now benefiting from a capital goods export boom to emerging markets, productivity is falling in countries like Italy and to a lesser extent, France. The complacency that surrounds Eurozone growth prospects will likely be shattered at some point this year putting pressure on the ECB to re balance its current inflation focus. In terms of the technicals and investor positioning, the rally already looks very overbought with the RSI at record levels and a potential double top developing below 1.60. The balance of risks at these levels is moving in favour of the dollar, not only against the Euro, but also Sterling as the UK has one of the riskiest GDP growth profiles globally if the credit crunch is sustained very much longer. An initial retracement to the 1.50 level against the Euro looks like a good target and I'm going short the June cross rate.

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