There’s no doubt that the rapid appreciation of the euro against the US dollar has been impressive. In fact, the EUR/USD pair has surged over 9 percent since January 1, 2008 as the Federal Reserve has aggressively slashed interest rates while the European Central Bank held a firmly hawkish stance despite a global credit crunch and broad instability in the financial markets. However, the EUR/USD rally can not go on forever and there are signs – from a technical perspective – that a turn lower may be nearing. What fundamental factors should we be watching that could trigger a sharp reversal?
1. The Federal Reserve Switches Focus Away from Economy, Financial Markets to Inflation
Economic data has started to suggest that the US economy is facing one of the Federal Reserve’s worst fears: stagflation. Indeed, the markets are already well aware that expansion has slowed dramatically, and the recent jump in the producer price index reflects rocketing costs at the factory gate. Is this trickling down to the consumer level? Yes. Consumer price gains accelerated in March, as measured by both the headline and core measures, which exclude volatile items such as energy and food. These signs of building inflation pressures have led traders to cut back speculation of aggressive rate cuts by the FOMC. Currently, fed fund futures are fully pricing in a 25bp cut to 2.00 percent on April 30 and only an 18 percent chance of a 50bp reduction, down from 42 percent just a week ago. The markets are almost always right when it comes to pricing in rate decisions, and if the FOMC policy statement released with the actual rate announcement suggests that inflation is now their predominant concern, the US dollar could actually rally significantly.
2. The European Central Bank Drops Their Hawkish Tone
One of the major reasons the EUR/USD pair has rallied so much is that the European Central Bank – namely, ECB President Jean-Claude Trichet – has refused to temper their staunchly hawkish tone. Indeed, inflation has surged in recent months, as it has around the world, which has left Trichet particularly on edge given the central bank’s price stability mandate. At the same time, the Euro-zone financial markets are also grappling with a credit crunch that threatens to take a heavy toll on economic growth in the region. Furthermore, the strength of the euro serves as a menace for export-dependent countries like Germany. As a result, some officials in the Euro-zone have attempted to stage some verbal intervention. The most recent example was from Eurogroup President Junker, who told the markets that they “did not correctly understand G7 message on FX” and he “does not consider the euro’s rise vs. dollar desirable.” This triggered a 100 pip drop in the EUR/USD in a matter of minutes, but this is not the first time that the EU President has complained about the strength of the euro, as he commented back when EUR/USD was trading at 1.38. When it comes to the euro, it’s only Trichet that matters, and until he either makes a direct comment that the currency is overvalued OR suggests that he is more concerned about the financial markets than inflation, the EUR/USD ascent is unlikely to fade.
Each time that monthly RSI on the EURUSD has been above 70 (considered overbought), the EURUSD has undergone a significant correction. In May 2003, RSI closed at 82 and the EURUSD fell 1,167 pips (top to bottom). In December 2003, RSI closed at 76 and the EURUSD fell 889 pips. In December 2004, RSI closed at 77 and the EURUSD fell 2,028 pips. Last month, the RSI closed at 85 (currently above 85). Also, notice the bearish divergence with rate of change.
The EURUSD uptrend since early 2002 is defined by a support line that has been touched on 5 different occasions (weeks). Clearly, the market deems this line important so we do as well. Extending parallel lines from the top of the trend and the middle creates a channel. The EURUSD is at the midpoint of that channel now, which is potential resistance. The support line is at 1.4099 this week and increases about 14 pips per week.
Since the 2005 low at 1.1638, tops in the EURUSD have respected a (roughly) 20/30 week cycle. This week is the 22nd week since the last top. If the cycle holds, then the EURUSD should be no more than a week or so from a top.
This wave count suggests that the EURUSD is very close to entering a 4th wave correction within the 5 wave advance from 1.1638. Wave 2 of the same degree (II) was a shallow correction so wave IV is expected to be sharp, probably a zigzag. Support comes in at the former 4th wave, which does not begin until 1.4967.
Finally, the short term pattern is also suggestive of a turn. The previous bull leg was a 5th wave that broke from a 4th wave triangle and triangles lead to terminal thrusts. Wave B would equal 127% of wave A at 1.6055 and 138.2% of A at 1.6118. These are potential reversal points although a reversal could happen at any moment.
[B]Written by Terri Belkas, Currency Analyst, and Jamie Saettele, Technical Strategist of Forex Capital Markets LLC, DailyFX.com
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