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CHOOSE YOUR LETTER, AND FX OUTLOOK

BORIS SCHLOSSBERG<br /><strong>DIRECTOR OF CURRENCY RESEARCH, GFT<br /><br /></strong>READING currency market research these days can be a little like watching Sesame Street. Every scenario assigns a different letter of the alphabet to the shape of the recovery. The direction for the dollar for the next 12 months could be determined by whoever is correct in their alphabet call.<br /><br />Pessimists envision a U-shaped recovery, believing the US economy has bottomed out and the rebound will be tepid. The bears&rsquo; arguments boil down to this: the deflationary forces unleashed by the bursting of the US credit bubble will continue to weigh on consumers and corporations, curbing a pick-up in demand. The bears imagine a protracted period of below-trend GDP growth as consumers and businesses retrench to rebuild their balance sheets.<br /><br />Optimists, on the other hand, forecast a V-shaped recovery as the US economy quickly resumes growth. They assume that the worst is over, that job contraction is finished, consumer confidence has stabilised and productivity at corporations is at decade highs. This combination should result in better consumer demand and corporate margins, in turn leading to bigger profits and more demand for labour, reinforcing the virtuous cycle.<br /><br />Finally, sceptics predict that the current rebound will end in tears, projecting a W shaped recovery. They think that the current pace of growth is stronger than most market observers believe, but say that as fiscal benefits begin to decrease in 2010, the US economy will hit a wall as the still-damaged private sector will be unable to generate enough demand going forward.<br /><br />Each recovery scenario has implications for exchange rates. If U is the future, US rates will be stationary for 2010 and perhaps beyond and the dollar will remain weak on carry trade flows. If a V recovery is taking place then Fed rates could tighten as early as the first quarter of next year and the greenback could be forming a bottom.<br /><br />Boris Schlossberg and Kathy Lien are directors of currency research at GFT. Read daily commentary on currencies at www.GFTUK.com/commentary or e-mail them at BorisandKathy@gftuk.com.