Top Trade of 2011

With winter holidays behind us currency trading should begin to return to normal this week as everyone slowly makes their way back to office. The focus of the week is likely to center on the U.S. non-farm payrolls report due this Friday January 7 at 8:30 a.m. Traders will no doubt will want to see if the steady improvement in weekly jobless claims will finally translate into a pickup in jobs for the overall U.S. economy, lending further credibility to the bullish argument that 2011 will be another year of growth.

However, this week I thought it might be a good idea to step away from the day-to-day gyrations of the market and take a longer term view. So without further adieu, here is my top trade idea for 2011.

Long EUR/GBP

Everyone hates the euro. In fact you can probably find more fans of Julian Assange within the U.S. State department than you will find euro bulls on Wall Street. The sovereign debt crisis that plagued the single currency throughout 2010 shows no signs of easing and credit markets remain concerned about Spain which as the fourth largest economy could wreak havoc in both credit and currency markets if it were to get in trouble this year.

Indeed, if Spain faces a financing crisis in 2011, all bets are off and euro is likely to make new lows. However, Spain’s government debt is only a modest 50% of GDP and the country has made tremendous progress in controlling its spending this year, which in turn should significantly lower its borrowing needs in 2011.

The short euro trade is essentially a bet that the Euro zone will fracture, but I don’t believe that will happen for political as much as economic reasons. China will do everything in its power to preserve the euro and the current multi-polar structure of the currency market.  The last thing the Chinese want to see is the return of the dollar to its primacy status as the only reserve currency in the industrialized world.  With 2.8 trillion dollars in currency reserves the Chinese have the firepower to support EZ sovereign debt needs without much of a disruption the overall credit market. Worse comes to worse, they will step in and buy Spanish bonds preventing another meltdown in European sovereign debt.  

I think the euro has a chance to rebound in 2011, but I believe that the safest way to play the turn is through a long EUR/GBP rather than EUR/USD trade.  Although the UK economy finally saw a rebound in 2010, overall growth was tepid at best and did not turn positive until second quarter of that year.

Looking Ahead

As we enter 2011 the UK economy faces a host problems including persistently high inflation, deteriorating housing market and most important of all, the prospect of draconian budget cuts in the public sector that could curtail spending going forward. With a budget deficit of more than 10% of GDP, the UK could face a serious financing crunch in 2011.

Bottom Line

In short, I believe that markets are too sanguine about UK’s financial condition and too pessimistic about the Euro zone's credit woes.  If sovereign debt problems persist in 2011, UK credit is likely to come under scrutiny as well in which case EUR/GBP will not lose much ground. See Figure 1, courtesy of FXTrek by Intellicharts.

On the other hand if credit concerns ease, the euro should stage a strong rebound and the pair could trade to .9000-.9500 by the year end.  A drop below .8000 however would indicate that the euro skeptics are right and I would abandon that trade under those conditions.