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FX: Should I Stay or Should I Go?

If you consider that the Fed is targeting asset prices inflation and t hat you should not fight the Fed, there are good reasons for expecting the current momentum to last for a while. Our FX indexes show that the best performer strategy since Jackson Hole is clearly momentum.
As far as there is no macro shock, the ongoing momentum should go on until year-end… What then could trigger a shock as fat tail events did not materialize in the US (mid-term elections results, QE2…). As we explain below, 1/ the major central banks positioning is now in place for the next few month 2/ the emerging market risk is growing but remains a mid-2011 issue. Over bullish views and market sentiment on many asset classes should suggest caution and lead us to look for mean-reversion risk potential drivers. One candidate is clearly the current dispute on the EFSF, its future beyond 2013, the mechanism of EU peripheral debt restructuring, the ECB warning on a new EU fiscal framework that does “not go as far as” a monetary union requires… How far will the CDS composite index against EUR/USD spread will widen before EMU internal problems are taken into account? Even though the short run may benefit from the ECB credibility, the fiscal un-sustainability will probably be a key driver of the euro next year. For that reason not only EUR/USD should retrench and a mid-2011 target of 1.20 for EUR/CHF should seem reasonable.

The G10 side of the currency war is over or at least in a short run truce as all major central banks have provided the market with clear indications on QE trends over the next few months. As the double dip seems to have been avoided (see below the stabilization of the global PMI index) the market can focus either on valuation, momentum and a new risk. The major risk may be inflation (mostly in emerging countries), which is clearly positive for real assets (commodities and stocks) and FX as long as 1/ capital flows to Em markets are not skewed toward domestic currency denominated bonds 2/ the “trilemma" does not preclude local central banks to fight efficiently against domestic prices increases.

Our central scenario is clearly based on the ongoing momentum. This apparent trend following forecast is based on the fact that the uncertainties on liquidity supply and on the economic backdrop has dwindle significantly over the last week. We will yet focus on two tail risks: 1/ within a few months, political and institutional issues should weaken the euro 2/ mismanagement of inflation could poise a risk for emerging market currency next year.

Disclosure: no position