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RISK TRADE IS STILL IN PLACE DESPITE DUBAI

<strong>JANE FOLEY<br />RESEARCH DIRECTOR, FOREX.COM</strong><br />THE shocking news that Dubai is on the brink of default is a reminder that the financial crisis still has a few tricks up its sleeve and the global economic recovery is far from firmly established.&nbsp; Economic data suggests that next year will see only slow growth in the US, Eurozone, Japan and the UK. <br /><br />The risk of a double dip recession in some or one of these countries during 2010 has lessened but it cannot be totally dismissed, given that repairing the fiscal deficit will have to start soon. Faced with this gloomy outlook for growth in most of the developed world and the shock from Dubai, investors might be forgiven for expecting that appetite for risk may be reined in aggressively into the New Year. However, it is not at all obvious that this will happen.&nbsp; <br /><br />Data from the Commodity Futures Trading Commission (CFTC) data for the week before the Thanksgiving holiday suggested that a lot of speculative long positions had been pared back. Hardly surprisingly but it is possible that speculators have started to book their profits for the year and may decide to sit on their hands for the next four weeks.&nbsp; <br /><br />But one of the major drivers of the risk trade remains firmly in place. As long as the market believes that Federal Reserve rates will remain low for &ldquo;an extended period&rdquo;, it is likely that the risk trade will remain a temptation and speculative longs will again be built up.&nbsp; <br /><br />The property bubble in Dubai may have burst but there has been a lot of talk recently about new asset price bubbles. It is not assets in the likes of the US and the UK countries that are in danger of running out of control &ndash; US equity valuations are a little stretched with the price/earnings ratio of the S&amp;P 500 modestly above the historical average, but it is hardly at levels that would be considered precipitous.<br /><br />However, property prices in China, Hong Kong and Singapore could be going through the motions of bubble formation. Since speculative inflows into these countries are being encouraged by very low Federal rates, the Fed could hinder speculative asset bubbles by hiking rates so that the dollar was no longer an attractive funding currency.&nbsp; <br /><br />The Fed, however, is unlikely to raise rates when its domestic economy is weak and expectations for domestic inflation are low. The Fed is not mandated to set policy to benefit any country but its own. The US economy at present is, like the UK, experiencing a tightening of credit availability on Main Street &ndash; a direct result of the lessons learned from the subprime crisis. <br /><br />Consumers are paying back debt and/or saving more to insure against potential unemployment or to make up for wealth lost during the financial crisis. As a consequence, the outlook for consumption in the US is weak, which reduces firms&rsquo; pricing power. <br /><br /><strong>REDUCED MOTIVATION<br /></strong>Like the Bank of Japan in the 1990s, it is possible that the Fed&rsquo;s ability to create inflation domestically may be lessened in the post-crisis era. This suggests reduced motivation for raising rates and supports an extension of the risk trade, which in turn increases the risk of asset price bubbles in some emerging markets.&nbsp; <br /><br />If the Fed is not going to take action to stop the flow of cheap money, the central banks of affected countries will have to take action. The first step should be a breaking of the dollar pegs, which are allowing those countries &ndash; most specifically China &ndash; to import the loose monetary policy of the Federal Reserve. A revalued yuan would re-direct some of the pressure of dollar weakness away from the effective exchange rates of the Eurozone and Japan.&nbsp; <br /><br />Eurozone officials visited China this weekend and once again the world was watching to see if China will make some effort to hike its exchange rate against the weak dollar. However, the markets were sceptical of any significant news since evidence to date had suggested that China is waiting for a strengthening in external demand before making such a move. <br /><br />This would offer no concessions to Eurozone and Japanese officials, who are&nbsp; worried about the detrimental impact of their currencies&rsquo; strength and their weakened economies. While intervention is possible, the success of such a policy is doubtful in an environment when the Fed has promised low rates for an extended period. So for now, Japanese officials and their Eurozone counterparts are likely to stick with noisy complaining in an effort to slow the greenback&rsquo;s fall. Assuming the Dubai news does not derail market confidence completely, the risk trade and dollar weakness may yet extend further. <br /><br />ResearchEMEA@forex.com