COUNTRIES’ public finances have dominated the headlines in recent weeks, but there is a good chance that this is just the tip of the iceberg. Whether it is wobbles in Dubai, debt downgrades in Greece, deteriorating outlooks in Spain and Ireland, or a pre-Budget Report in the UK, all of these countries have a long way to go before they are out of the woods.

Only Ireland has arguably moved closer to resolving its budget woes – but last week’s brutal spending cuts are likely to be followed by more tough budget measures before things can be said to be truly improving.

This focus on countries’ credit worthiness will continue well into 2010 – it is a natural evolution of the repair process of financial markets, in more ways than one. At the height of the crisis, few argued against the need for a huge fiscal response from governments, but spending binges must eventually be paid for.

Furthermore, high levels of unemployment will only exacerbate the size of the deficit and taint the budgets of all industrialised countries, not just those affected by property bubbles and banking crises. This will have an impact on the market’s perception of these countries’ budget deficits and their credit worthiness.

The market’s willingness to differentiate between risk on a country or regional level is an important part of the repair process in financial markets. Credit worthiness is at the core of any assessment of risk and its ranking of risk should be instrumental to the pricing of assets and currencies.

But during the course of 2009, a strong correlation has been sustained between stocks, oil prices, the S&P 500 and euro-yen, while the dollar index has been inversely correlated with these risky assets. An exception was Aussie dollar-US dollar, which started the year trading in line with risky assets. Since the spring though, Australia’s good economic fundamentals have allowed it to outperform.

Even though the overall rally in risk since the spring suggests that broad-based fear has been dispersing, strong correlations between some risky assets persist. Forecasts of slow levels of growth for most of the G10 in 2010 suggests that there are still a few more negative shocks in store for the markets in the coming months.

That said, reduced levels of fear should allow fundamentals, including assessments of credit worthiness, to play a greater part in asset allocations. This is likely to result in a breakdown in many of the correlations that have characterised markets over the past year. Rather than move indiscriminately in and out of risk, markets will gradually return to assessing individual markets and sectors on their merits.

For the FX market, the big question is when the dollar will give up its negative correlation with risk. The answer is clearly when the greenback is no longer considered to be a funding currency. The reaction to the much better-than-expected December payrolls report brought forward the perceived risk of a Fed rate hike and thus has given the market a taste of a stronger dollar.

It is possible that the dollar has entered the first phase of a cyclical recovery against the euro, although it remains by no means certain whether there will be sufficient momentum in the US economy for the Fed to start hiking interest rates before the second half of next year. Given this risk, more good US data will be needed to stop euro-dollar rising back up towards $1.49 over the coming few months.

Assuming the dollar does enter cyclical recovery against the single currency over the first half of 2010, this does not have to mean the end to the risk trade – instead, the risk trade will evolve. It is quite feasible that the greenback will continue its downward adjustment against other currencies while simultaneously rising or remaining stable against the euro.

Strong growth in the Asian region suggests that the dollar may continue to fall against the Australian dollar as well as against some Asian and other high-yield currencies next year, assuming the global economy remains on the path back to health.