Imbalance of trade

It doesn't seem to matter just how bad the situation appears to get for the US economy, the two-year-old euro is still struggling to break back into trading levels near parity with the dollar.

Even now, with commentators more and more convinced that the US recession will be more prolonged than the short, sharp snap first expected, the single currency can do no more than hold its own on the foreign exchanges.

Once again, speculative accounts, including many of the macro hedge funds, are starting to set up structured short positions in the euro against the dollar. With the euro currently standing at around $0.9350, many fund managers are looking at the continuing disappointing picture painted by the eurozone balance of payments.

Despite the falls in US capital markets (which have seen Nasdaq drop to 60% below its March 2000 highs), Euroland's balance of payments still shows a negative flow from the foreign exchange markets as direct investment flows seek out homes in dollar-denominated assets. This suggests that the euro's rally in late 2000 and early 2001 was driven by speculative buyers who are now jumping ship.

One of the main pieces of evidence pointing towards speculative accounts either bailing out of existing long positions or setting up new shorts comes from the latest IMM exchange data, showing net long euro contracts at a four-month low.

However, the fallback in the number of speculative positions still open could leave the contract set for a sharp spike higher as the weight of profit-takers has been eliminated to a large extent.

Other hedge fund buying of the euro has been undertaken in order to fund attempts to return to the US equity market. Although heavyweight technology stocks don't yet appear to be totally out of the woods, there has been some selective buying by funds "bottom fishing". This has seen many UK-based funds borrowing in euros at lower rates than in the US or UK and switching out of the single currency to dollars.

Short-term trade recommendation:

With interest rate differentials having less and less impact, the Fed's willingness to cut rates is keeping the dollar strong on hopes of stronger US growth in the second half of 2001. On that basis, the euro is looking toppy at the upper level of its downward trading band. Look to be short the euro against the dollar at $0.9350, with the aim of taking short-term profits around $0.9050, the lower end of the recent range.

Long-term trade recommendation:

Despite the continued weakness of US asset markets, the FX flows between the dollar and the euro remain euro negative. This doesn't look like changing any time soon. Added to this is the uncertainty surrounding the upcoming Italian elections with the centre-right coalition leading in the opinion polls. The next three to four months could be rocky ground for euro bulls. Be short against the dollar, with the potential to test the downside to $0.8650.