Euro Reverses

The euro had made new highs for the year earlier today in response to calls to diversify Chinese reserves and after trading broadly sideways in Europe has broken down in North America. With the hitting of stops, the euro has been pushed through Friday's lows, near $1.4986. A close below there would be what technicians call a key reversal. The last time such a pattern was recorded may arguably have been on Dec 29, 2008. The session before, Friday Dec 26, the euro spent a quiet session, the day after Xmas and Boxing Day in the UK, in narrow trading ranges (at the time when volatility was quite elevated). The range was roughly $1.3989 to $1.4119. On Dec 29, the range was $1.3921 to $1.4364 and the close was near $1.3927. The euro then went on to fall about 10.6% against the dollar before bottoming in early March.

Today's price action is inflicting technical damage on the euro chart. The next level of support is seen near $1.4830-40. A convincing break of that area would encourage sights to be set on the $1.4675 area as the next target.

Sentiment is one-sidedly dollar negative as it may have been in years. Although that alone makes the contrarian case interesting, we have suggested three factors to help identify a euro top. First, we have consistently maintained that the absolute and low US interest rates, coupled with the deluge of liquidity, has contributed to the renewed dollar use as a funding currency. There has been some improvement recently. The spread between the US and Germany's 2-year yield narrowed in the US favor by 11 bp over the past week. The March and June Euribor-Eurodollar spreads have narrowed in the US favor and currently are near two-week lows. The rate moves are too small at this juncture and have not been sustained long enough to feel confident in calling a major euro top.

Second, we identified the pattern by which the dollar is sold off not so much as a vote of no confidence in US policy, but as a vote of confidence in the recovery story. This has been reflected in the euro's correlation with the S&P 500. Running the correlation on the percentage change of the euro-dollar exchange rate against the percentage change in the S&P 500 is 61% for the past month, 50% for the past 3 months, and 49% for the past six months. This suggests that the pattern may not yet have broken down. It would have "felt" better if today's dollar rally took place alongside rising stocks.

Third, we have suggest that a technical reversal pattern may emerge before the fundamentals fully emerge to justify the dollar recovery. Today's price action may qualify. But one of the striking characteristics of the euro chart is that extremes are often seen twice of just about. Recent example would be the euro's high from last year, both in April and July the euro briefly poked through the $1.60 level. Then as the euro was bottoming, it approached $1.23 in late October 08 and in this past March retested it when the euro neared $1.24.

Where does it leave the euro-dollar ? Short-term participants may be better served playing from the short side as the long trade still seems crowded. Medium term investors may want to take things one step at a time and monitor the price action. Watch the $1.4830 area and then $1.4675. On the upside, a move back above $1.4965 may be an early indication that the down leg is over.
Euro Reverses Euro Reverses Reviewed by magonomics on October 26, 2009 Rating: 5
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