The decline in EUR/USD today does little to change my fundamental view that what we are experiencing is a reflationary cycle as the deflationary forces of the European sovereign debt crisis have thus far not manifested themselves in a sustained way.

The market got particularly frothy yesterday after the WSJ reported the Fed was considering some modest further steps to ease quantitatively. The ISM indexes this week show the economy holding up better than feared and may delay or derail the move toward further extraordinary measures from the Fed.

The bulk of the gains in recent weeks have relatively little to do with the relative merits of  the US or European economic recoveries and more to do with the fact that Europe survived what was a truly existential sovereign debt crisis. What we have is a reversion to the norm.

As long as we hold above the 1.3100 level, I expect the macro picture to remain unchanged: A world tentatively increasing its appetite to assume risk as investors veer away from the extreme pessimism of late spring.

In the middle of last week I tried to explain the macro picture as I saw it unfolding. I still see it unfolding the same way. It is worth a read if you missed it.

It looks to me as though the market has come to terms with the idea that the US economy is slowing. It also appears that the market expects the US to avoid a second full-blown recession and limp along slowly for the next quarter or two. Bad is okay, so long as it doesn’t get badder…

What the market did not expect was the European economy to show the resilience that it has thus far in the face of a sovereign debt crisis that nearly ended the European experiment. Asia continues to grow robustly, as do emerging markets.

If we view the global economy as a 5-cylinder engine, you have the US struggling, Asia more or less booming, along with emerging markets. Europe is unexpectedly humming –for now– (including the UK) and Japan is benefiting from Asian strength but not doing as well as it might. Taken together, you have a macro backdrop that is significantly brighter than we assumed just a month or so ago.

If it continues, it also suggests the US may yet right itself, especially if the government begins to bow to electoral considerations and moderates its policies to avoid chaos at the ballot-box come November. All this argues for better risk appetites in the next few weeks and months in my view…

With the stress tests out of the way, the market has turned its focus toward the global macro backdrop.

China is doing what China does, chugging out loads of exports and spending bucket-loads on building out an infrastructure from scratch. It may be slowing at the margin, but that is by design.

Europe has slowed far less dramatically than the market as a result of the sovereign debt crisis and the US is showing pockets of strength amid a general slowdown. All in all, not a horrible backdrop.

The market is reflecting that backdrop, selling the safe-haven dollar and buying pretty much everything else. In a reflationary world, that is a virtuous cycle. Long may it last…

Currencies are trading in risk averse fashion at month-end though the related markets are not showing a great deal of distress today. As noted yesterday, there seems to be more of a macro shift taking place these days rather than short-term headline chasing.

The macro view that the dollar was destined to reached Zimbabwe-like depths and that commodities would reach levels several times higher than today’s prices seems to have been dashed. Central banks continue to let lapse liquidity programs that programs that are no longer needed and fixed income markets have adjusted accordingly, With US yields 40-50 basis points higher than they were just two-months ago.

The dollar will not strengthen in a straight line, but the melt-down risk (hope?) that was priced in by the market is now priced out and technicals are such that long-dollar positions are preferred. If this results in less reserve adjustment, even at the margin, the dollar will benefit as Asian, Latin American and Middle Eastern central banks will be less inclined to blindly buy EUR to diversify reserves.

Today’s improved US data is just icing on a much bigger global asset shift, in my opinion. Forex trends can be very long-lived and powerful. Fading dollar strength is not recommended.

Day after day we write about risk aversion as Chinese tightening steps pop up or Greek debts implodes…What we haven’t done is take a step back and look at the bigger picture.

The dramatic currency moves over the last two months seem to be the result of a larger macro shift that is underway. For the middle months of 2009, the market was more than happy to borrow and sell dollars against anything with a yield or with a chance of price appreciation. The US was perceived to be circling the drain and hyper-inflation was just around the bend.

In the last two months, we’ve seen a shift in market behavior. Traders are no longer willing to buy gold at any price. They are no longer willing to borrow dollars to buy the currency of any country where China might one day source a natural resource. In short, we’ve become more risk averse, but not as a result of the headlines of the day (which punctuate that risk aversion) but for fears that a dollar bubble has been created.

China’s Zhu Min put a price tag on the carry trade yesterday in Davos: $1.5 trln. It would appear we’ve spent the last few months covering some of that $1.5 trln short and likely have a ways to go before we are done.

With reports of Asian central banks now selling EUR/USD on rallies at lower and lower levels, expect consolidation in the single currency in the near-term, not a swift reversal to the topside.

The surprisingly firm pound of recent weeks is another sign that the heavily shorted currencies of 2009 will be the out-performers of early 2010.

I’m still trying to connect the dots from this week, but they don’t much connect.

Gold took off for the stratosphere. China, right? I guess.

Bonds yields fell toward range lows even though another $70 bln in supply was issued. As gold soared.I still don’t get it.

“We’re worried about your currency, but hey, how about another helping of those long-bonds over there…”

Still does not make much sense. Oil falls $3.50 on a day gold makes a new trend high?A weekly close below $70.

I could go on and on.Most of the correlations on which we’ve relied in recent months are badly breaking down and traders are trying to come up with new relationships on which to lean. USD/JPY is no longer a risk barometer though it looks as though EUR/USD is plying that ground.

Maybe enlightenment will come with a weekend’s reflection…Hopefully the markets make more sense to all of you than it does to me at the moment.

For those who have not already seen this one, Goldman and Morgan Stanley analysts have hiked their forecasts for 2009 Chinese growth. Goldies revised their expectations from 6% to 8.3% and Morgans raised theirs from 5.5% to 7.0%.

The head of the BOJ said that the US economy needs to work out excesses including household over-indebtedness. For more on his comments please click here.

The Nikkei is down over 0.5% in early trading with automakers and one or two financials to blame. Things in Australia have slipped slightly into the red after a positive start to the day. South Korea’s Kospi is currently in positive territory with better than expected GDP numbers this morning.

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