Forex Investment and Currency Trading

• Recommend to establish a long EUR/USD position at 1.2760.
• Target a return to 1.4180, the 50.0% retracement of the decline from the pair’s record high set on July 15 to the October 28 low.
• Place a stop on a two-day close below the October 28 low of 1.2330.

The recent advance of the USD rests on a weak foundation. The dollar was driven higher by a severe shortage of USD liquidity abroad and a bid created by the deleveraging process.

One of the earliest sources of support during the financial crisis for the USD seems to have come from rising tensions in the money markets, as exemplified by the record high levels posted by the three-month USD LIBOR – OIS spread. The severe lack of USD liquidity created incentives for foreign banks to buy dollars in the currency markets, creating a way to meet USD funding needs without paying the soaring interest rates associated with the Eurodollar markets. However, the extra-ordinary measures introduced by global central banks to ease tensions in the money markets have largely removed this source of support for the dollar.

Furthermore, the dollar support created by the global deleveraging process has also been reduced. The repatriation of foreign investments to the United States is slowing sharply.

These sources of support for the dollar are fading as the last month of the year approaches, a time when the USD has historically weakened. Over the last ten years, the USD index has demonstrated a clear and consistent pattern of seasonal weakness during the months of September and December, a phenomenon that may have softened the USD in late September of this year and will likely do so again in December. These short-term factors suggest that EUR/USD has likely already hit its lowest level of the year.

Furthermore, the onset of quantitative easing in the United States has created additional downside risks for the USD. The rapid expansion of a country’s monetary base should prove to be inconsistent with a strengthening of its currency. The Federal Reserve announced on Tuesday two new programs that will add significant assets to their balance sheet – a $600bn program purchase of agency debt and agency mortgage-backed securities and the Term-Asset Backed Securities Loan Facility (TALF) that will be used in early 2009 to lend up to $200bn against asset back securities. The massive injection of liquidity into the US banking system could eventually lead to a tripling of the monetary base, a massive creation of USD liquidity that could undermine the stability of the USD.