Is a Euro Top or Correction at Hand?

  by Kevin Pendley

Murmurs are beginning to percolate that the interest rate easing cycle from the Federal Reserve is nearing an end, and that a tightening move is on the horizon. While it might be premature to speculate on the end of the easing trend in front of a meeting by the Federal Open Market Committee Wednesday (at which the Fed is widely expected to slash rates once again by 25 bps) it is a tantalizing piece of a puzzle that hints at a potential top in the amazing bull market charge of the euro currency against the dollar. 

Just how spectacular has been the plunge of the U.S. dollar versus the euro in recent years? Back in July 2001, the relatively freshly minted euro tumbled to a low against the then-mighty greenback of 0.8352, which meant you and I could travel to Germany or Italy and receive about 120 euros for a quick $100 souvenir shopping spree. Fast-forward to today, and that same $100 bucks gets us only about 63 euros, which means my relatives have gone from designer sunglass gifts to reprinted photos of me standing in front of the Leaning Tower of Pisa. Of course, all of that is said tongue in cheek; although the euro was introduced in 1999, they didn't launch physical notes and coins until January 2002. (And what are the chances I was really buying designer sunglass souvenirs anyhow?) 

I do love to travel all around the world, and I can tell you that having your purchasing power slashed in half can be a very bitter pill to swallow. Suddenly I have less desire to drive a Porsche on the autobahn through the Black Forest in Germany, or relive the barbaric history at the Roman Colosseum, and an intense desire to sit on my back porch and wonder how green the grass will grow this summer. 

Back to our original topic: if the Fed is ready to stop easing rates, why would that be supportive to the U.S. dollar and stall the never-ending upward thrust of the euro? Because some of the key factors that influence currency rates are interest rates, investment patterns, long-term business cycles, balance of payment trends and political changes. 

When the Federal Reserve shifted into an easing mode last year, it signaled that all was not right with the American economy. Sure enough, the United States has stumbled into a recession-like slump in recent months. But if the Fed is willing to shift back to neutral, then tightening, it would suggest that the downturn in growth is less risky than inflationary issues. A stronger U.S. economy would make the greenback attractive for foreign exchange investors and would likely spark a recovery in U.S. equities, which in turns would drive demand for U.S. dollars from overseas investors who would jump on the U.S. stock market bandwagon. Make no mistake: a strong economy almost always bolsters a country's currency value. 

In last week's FX Column, I noted that currency markets tend to be wonderful long-term trending instruments. After all, economic patterns tend to play out over a long period of time. Consider this: being on the right side of the seven-year bull market run in the euro currency generated a 93% profit. From a derivatives perspective, a 10-lot buy-side transaction in euro currency futures would have generated a profit of $914,125 dollars, with an estimated brokerage cost of $14,000. You do the math. It's tasty. 

What really tempts me about this trade opportunity is the current chart structure. The euro/dollar pair is overbought on long-term charts and appears to be entering either a correction, or an outright downturn given the current pattern. Risk and reward is relatively tame, as any move back to new highs would be enough to stop out long-term traders, while short-term traders could tighten that risk more toward 1.5897, or about 253 bps, from where the market was trading April 24 at midday when this column was penned. If the euro does begin to wobble, then next week I'll look at some of the potential downside targets for long dollar/short euro trades.

Kevin Pendley has been involved in financial and commodity markets for two decades, including more than 15 years with Knight-Ridder Financial News/BridgeNews.  In addition to his work at 4xAdviser.com Weekly, he is a contributor at SmallCapInvestor.com where he writes a weekly technical analysis column on the Russell 2000.

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