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Don't fight the Fed, nor the ECB!

I highlighted last month two major tail risks for the FX market and in particular that “within a few months, political and institutional issues should weaken the euro”. Months turned into days as the European crisis quickly erased the risky assets prices gains that followed the announcement of QE2. The mounting divergence between our “cohesion countries” CDS composite index and the EUR/USD finally-mean reverted as the European unit weakened sharply.

Drawing upon the current crisis to make a medium run forecast is precariousgiven the intricacies of the factors at play: political/sovereign divergences; opportunity to as for bailout schemes (EFSF, EFSM) ; dispute over the creation of a debt restructuring European programme (how to bail in the private sector and the risk of a dual sovereign debt market) ; liquidity vs. solvency risk… We would just say that our macro model suggests that a further fall in the EUR/USD would not be at odd with medium run fair value; that technical analysis suggests a lower EUR/USD in the short run and that a domino effect may not be ruled out in spite of the recondition of the fixed tenders / full allotment MRO and LTRO by the ECB and its ongoing purchases through the SMP… Lastly, as the chart below shows, core countries may also appear less safe as, for instance, Germany could carry more bailout residual risk (explicit guarantee) were other non core countries to ask for ECB/IMF/EU help.

A striking feature of the last few weeks has been the resilience of the VIX to reflect the retrenchment of risky asset prices. There might be some technical factors, but it also highlights that the lingering forces that prevailed before November have not vanished: abundant liquidity and growth momentum (US and Asia PMI for instance). Baring a very bad outcome for Spain in the short run (or a strong internal European disputes), those forces could quickly come back as the main driving forces of risky asset prices, hence major FX pairs (a look at the last chart shows that no directionality is to be expected from yields spreads now that the ECB won’t be able to exit any time soon due to its implicit and forced subsidy of non-core banks…).

The likelihood of a sharp retrenchment of the EUR/USD in the short run is low given the strong commitment of the ECB to provide liquidity to both banks and the EGB market. One should therefore not fight the ECB, nor the FED as Ben Bernanke said during a 60 Minutes ITW that it would be “possible to do more” in terms of QE. The last chart highlights that the Euro crisis is perceived as idiosyncrasic and did not brought the overall risk aversion higher as it did in May… A crisis learning curve?