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Swiss franc was a profitable short

I believe the Swiss central bank and Swiss big business are absolutely thrilled to depreciate the franc because a small, open Alpine economy where exports are 50 per cent of GDP is hostage to the imported deflation risks of an overvalued currency that is the world's geopolitical safe haven money of choice. The gnomes of Zurich, contrary to conventional wisdom, went short Swissie and long dollars with a vengeance last week.

Now that war in the Middle East has begun it makes sense to recalibrate conventional wisdom about risks, opportunities and strategy ideas in the global foreign exchange market. This is the subject of not mere academic interest to us here in the UAE. For instance, in March 2002, I believed the dollar was grossly overvalued against the euro and believed that all the smoke signals from the US Treasury and the "smart money" hedge funds in New York suggested a major dollar sell off reminiscent of the Plaza Accord greenback bear market on a smaller scale - was imminent. The March 2002 column "the coming collapse in the dollar" recommended aggressive buying of euros at 86 cents. This was not a bad trade, if I permit myself a dose of quintessential British understatement. The dollar lost 25 per cent of its value against the euro in the 12th months after the publication of my column titled "the coming collapse of the dollar" in March 2002.

Think about the awful implications of what happened to the dollar for any saver or investor in the UAE. If you had switched from dirhams / dollars into euros or Swiss francs in April 2002, you could have saved a 30 per cent decline in value of your savings in a bank account. Sadly, to ignore currency markets is a sure path to financial suicide.

At this point, the British pound might be near a strategic low against the dollar at 1.54 -1.56. The revolt by 139 Labour MPs in Westminster against Tony Blair was the biggest parliamentary revolt in a governing party since Neville Chamberlain got the boot when Hitler's Panzers attacked Holland, Belgium and France in the spring of '40. Blair's political risk has accelerated sterling's fall as the prospect of regime change in 10 Downing Street is now hostage to the epic Allied effort to force regime change in Baghdad. Yet, despite the stratospheric prices in London's West End, sterling is not overvalued on a PPP basis against the dollar. On the contrary, sterling's rise since 1997 is justified by Gordon Brown's independence for the Old Lady of Thread needle Street, a low fiscal debt to GDP ratio and Britain's financial resurrection under Tony Blair. Morever, the Bank of England's MPC voted to keep interest rates on hold at 3.75 per cent after their shock cut in early 2003 rattled sterling.

International bond flows, not cross border equities or global mergers, drive currency rates. So repo rates, carry costs and yield spreads are critical to forecast FX rates. If the Bank of England does not cut rates while the Fed or the ECB is forced to ease again to avert recession, then sterling could be near a bottom in the early 1.50's range. The risks of a property bust in Britain in the biggest risk to sterling. If real estate prices collapse, consumer spending will swoon and the High Street will roll over. After all, John Bull owes almost a trillion quid in debt and both mortgage debt / house prices are at bubble levels at a time when the City of London and the global economy are shedding white collar jobs at an alarming rate.

Yet as long as the Bank of England does not cut rates again, it is not axiomatic that a property, hard landing will doom sterling. After all, Britain is still not in the economic dog house, unlike Germany, Japan or even the US. Even though the base rate is at its lowest since Winston Churchill last lived in Downing Street, sterling is still a high yield currency in an international context. The Iraq war risks - oil shocks, torched oilfields street fighting in Baghdad - are all asymmetrically sterling bullish. To borrow a phrase from Chairman Greenspan's Fedspeak, "the balance of risk" favors sterling now.

Beyond the war in Iraq, the dollar just cannot avoid its structural downtrend. A $500 billion dollar trade deficit, a $2 trillion debt owned to foreigners, the most leveraged corporate balance sheets in history, Wall Street in a post bubble zombie trading range, oil shocks, the lowest consumer confidence since 1992, real zero interest rates, an overvalued Treasury note market, job losses, anemic retail spending, a brain dead Silicon Valley - why would any body in his right mind bet on a sustainable dollar bull run? Sure, we could see fast and furious bear market dollar rallies, as we saw last week. Yet a sustainable dollar rally requires that America find Osama, Saddam, a new Fed Chairman, a cure for cancer and the Tooth Fairy. Once the fog of war lifts in the Middle East, this might be the most compelling reason to bottom fish sterling around these levels.

I believe sterling could well trade in a strategic range of 1.54 to 1.68 in the next six months. Therefore, it makes sense to sell cable strangles at these strikes. I also would take profits on my short Swissie / long dollar trade and initiate new positions to buy sterling against the Swissie, taking advantage of both the carry and the FX option volatility curves.