US Dollar Disequilibria - Long Yen/Short EUR

I am struggling to get near term directional view on FX at the moment. My sense is that the US dollar could trade at the strong side of a trading range. Euro will see 1.33-1.46 while yen threatening to break 90 level. Liquidity to be thin, volatility to be high and risk-return to be meager for most trades.

Clarity only comes on stream if the US financial sector bails out bill passes and how markets trade post-quarter end. It really gives everyone a serious thought of how much of the recent price action is fundamental discounting and how much is sheer noises, especially when the Euro-dollar overnight FX swap implied yield for dollar surged to a high of 54% in late September.

As dollar is struggling to find its balance, the near term gravity is currently at trades of Euro/Yen with rising pressure for the ECB to cut rates sooner and deeper than before. Many central banks have gone from buyers to sellers of FX reserves. If the dollar benefits from rate convergence as ECB taking the baits, I expect the Yen to benefit even more, partly thanks to its current account surplus and partly inflows of Japanese investments overseas, given the extreme FX vol and higher default risk, which exacerbate the challenge for the Japanese of finding an overseas asset worthy of the risk.

One should also take note that markets are differentiating credit risk across Europe’s sovereigns, which my view is that it will rise sharply in coming months. For example, I don’t expect the Swiss National Bank (SNB) to cut rates as much as the Bank of England (BoE) and ultimately the ECB.

Anything beyond that I doubt this dollar rally can persist as pressure for aggressively reflationary policy in the US is rising. The deterioration in the US economy should continue and TARP financing will add pressure on the Fed to ease further, hence the underlying budget deficit and the Treasury’s other programs linked to this crisis. As a result, the front end US yields will see rising pressure, of which the market will have a right to fear monetization of this debt.

• My view remains staying short USD/JPY, but to be balanced with concern of elevated risk aversion and high FX volatility. Downward pressure on yields in the G10 will help diminish Japan’s yield disadvantage. This view could equally be expressed via short Euro/JPY.

• On the same count of surplus in current account and low yielder profile, I short EUR/CHF, but the currency is obviously more vulnerable to central bank easing policy. However, I doubt that the SNB will cut rates prior to the ECB and that the ECB will ultimately cut by more than the SNB.

• The sharply weaker data from UK and highly likely BoE to cut rate in October, if not in November leads me to sell sterling.