Saturday, August 9, 2008

EUR/USD medium term outlook

These last few weeks, I have been holding the belief that, for the next year or so, the EUR/USD will have a high volatility between 1.4 and 1.6.
This week, it dropped from 1.55+ to 1.5, that's an impressive drop, and we start hearing from a possible big trend reversal, possibly the outset of an upward trend for the USD, the materialization of the strong USD policy promised by Paulson and Bernanke beyond the customary rhetorical value such chantings have.

As of now, I have been considering the risk of being wrong on the upside higher than the one of being wrong on the downside. Should I then reconsider my approach ?
Anyway, here is the details of my thought so far, up for comment:

My first assumption is that EU economy is still overall structurally healthier than its US counterpart, even though some banks have suffered from the credit mess, the level of the write-downs (and the depth of their consequence in the overall economy)is still very far from what we saw in US.

Secondly, I assume that there is a general psychological bias for the USD, whereby the investors actions (in EUR/USD particularly) over-react to bad EU news, and under-react to bad US news. This bias is actually justified in view of the market dynamics, where the european markets mostly mimic the US market. What I mean by bias, is that it does not reflect pure fundamentals, but is mostly a psychological attitude in the mind of investors that have spent most of their lives with considering the USD as the reference currency, the safe haven away from the world uncertainty. This bias however is really challenged by the current crisis, and it tends to fade a bit, and may well vanish totally, which is why, until now, I considered my risk of being wrong on the upside higher.

Now, considering that Paulson and Bernanke really mean to walk the talk, can they really do it? Clearly, the Fed may be able to do a few things, especially with the support of the ECB and the BOJ, both having a strong interest in a strong USD to ease the pressure on their respective economy. We can then reasonably expect a collaboration between the three largest players on this market to push for a strong USD. But is it enough?

US economy is expected to deteriorate further. According to Krugman, some bad loans are going to mature up to 2011, real estate is expected to continue its drop, being only half-way through according to some estimations.
In addition, USA is going to have a new government in less than 6 months, one who will inherit some serious liabilities from the current one. A new government, elected on the current buzzword of "change", can hardly be expected to have a tight budgetting poliy in his first year, especially in view of a reform of healthcare, of necessary expenses on infrastructure, on energy policy,...etc.
Such a policy may seriously strain at a strong USD policy, which I rather see as incompatible with running an ever-increasing deficit (something about which the investors should see the EU, despite some very bad members, relatively immune from, given the conditions of the Growth and Stability Pact).

So, will the USD pull it off, and are we really seeing the first signs of a complete reversal, or is it just the last song of the swan before its slide into the 1.8 or so, just awaiting the next big write-down ?