Short-Term Euro Movements Continue to Confound the Laws of Gravity

by Guest Author Tom Cleveland, forextraders.com

Predicting the weekly or even daily movements of the Euro under today’s market conditions has been a confusing exercise at best, often defying the “odds” that have been heavily weighted for its demise. The relentless stability of the currency, especially versus the Dollar, has made many traders question their livelihood of late, particularly when the long-term picture, one that expects a declining relationship, seems so solid. Academic case studies arise from such scenarios, but the five-act Greek tragedy appears to be plodding along, teasing us with its various twists and turns.The latest “scene” of this play opened last Friday when Standard and Poor’s finally announced late in the day its downgrade of France and eight other countries in the Eurozone. Markets moved in a downward direction, as expected, but not nearly as severely as they did back in August when the same fate befell the United States. After a few percentage points on the downside, the markets swiftly rebounded and started to rally. With the majority of the trading community preparing to “short” the Euro this week, the “EUR/USD” currency pair, the contrarian that it has become, produced nearly five days of gains.

What are the lessons to be learned from this arbitrary behavior of the Euro? Longer termed forex charts are typically the vehicle for finding these types of answers – the daily chart below will help provide insights:

From a long-term perspective, the Euro has been “channel-bound” for much of the past year, “hugging” to a valuation over $1.40 until QE2 expired in June and then falling through $1.30 as efforts to prevent a default in Greece seemed futile. Many experts had set this latter target earlier in the year, but one industry “guru” sees a grimmer picture on the horizon. John Taylor, the founder and chairman of “FX Concepts”, the world’s largest currency hedge fund, has stated publicly that he expects the Euro and the Greenback to reach parity in the near-term. Timing is the only issue.

Much of the consternation of the previous year, however, dissipated when it came to light that banks, companies, and individuals in Europe had been repatriating massive amounts of assets back to the homeland to buttress up domestic foundations for the storms to come.  A similar scenario played out in Japan following their horrific earthquake and tsunami disaster back in March.  Asset repatriation creates increased demand on the “buy” side of a domestic currency, thereby forcing a type of temporary support in the market.

Whenever this “temporary” support faded, the Euro has resumed its channel-driven downward path, until the current events taking place, as signified by the “orange” oval on the above chart. The upward surge of the past week came as a surprise to most traders and forex brokers alike. Many suggestions have been proffered to explain this show of strength demonstrated once again by the “fickle” Euro. Here are a few:

•Markets had already overly discounted the Euro since the downgrade from S&P had been anticipated for weeks. Once the news was out, a brief resurgence offset the heavily pessimistic attitude of the trading community;

•Bond auctions in France and Spain went off without a hitch with strong demand and lower yields and with no apparent premium paid for higher risk attributes. Liquidity is a good thing, highly valued by the market, which still has not forgiven the rating agencies for their “AAA” ratings of mortgage-backed securities;

•The week has also witnessed broad “short covering” activities in all Euro currency pairs, attributed to an underestimation of the power of the European Central Bank’s long-term refinancing operation (“LTRO”). With billions in new liquidity rushing in to save the day, traders with heavy short positions in the Euro have finally caved in and abandoned this strategy altogether;

•Greek negotiations with their existing bondholders have bumbled along for days, but many expect a favorable resolution shortly that is required if Greece is to rollover a massive portion of their national debt in March. The sticking points have been the interest rate, now narrowed to 3.5% versus 4.5%, and the size of the “haircut”, now believed to be around 68%;

•Lastly, a modest recovery has been taking place in the United States, and the correlation between the Euro and the S&P 500 index has resumed, if only for a brief period.

With so many “guesses” afoot, the real “cause” for this recent “effect” may not center on a single issue. The fact remains that Commitment of Trader reports still show twenty weeks of increasing short positions for the Euro in its weekly charting trends of net interest in our futures markets. This “gravity” will surely weigh heavy on the Euro’s future prospects if these positions continue to increase. Caution is this week’s watchword.

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About the Author

Tom writes for forextraders.com and after making his career in the international payments industry, he now enjoys spreading his investment analysis by writing about various topics on the subject.