Euro/Yen Shorts Another Approach to Euro Pullback

  by Kevin Pendley

In last week's Foreign Exchange column, I recommended buying the U.S. dollar via short euro/dollar positioning. At the time the story was penned, the euro was trading at about 1.5850 (I wrote the story one day before the publishing deadline). Right now, the euro/dollar pair is trading at 1.5460, which means the market has tumbled an impressive 390 basis points, or nearly 2.5% in a week. A 10-lot trade in futures on the euro/dollar contract would have yielded a profit of $48,750, which isn't bad for a week's worth of work. 

Trust me, all this back patting does have a purpose for this week's FX spotlight. Working on the "sell euro" theme, another cross on my radar screen is the euro/yen, which shows some modest signs of being near a top and has nice risk/reward parameters.

As we noted in last week's column, the collapse of the U.S. dollar has brought about a painful loss in purchasing power for those of us who like to travel the world, especially in Europe. Well, it's a story that Japanese travelers can relate to as well. Since the euro bottomed against the yen back in October 2000, the euro/yen cross has soared some 90%, climbing from a low of 88.97 to a record peak in July 2007 at 169.04. 

Currency markets tend to be wonderful trending instruments, and the relentless upside charge in euro/yen has been on a seven-year run that rivals the dramatic decline in the U.S. dollar against the euro FX standard. 

Euro/yen and euro/dollar have seen a high correlation in recent years as both the greenback and the yen have suffered against the almighty euro, and if a euro top or major correction is at hand, then both crosses will likely benefit in the weeks ahead. Selling the euro against the yen can simply be another play to avoid a potential prolonged softening or "double dip" in the U.S. economy in the weeks or months to come. 

Fundamentally, Asian currencies are undervalued significantly against the euro. According to Goldman Sachs research team, Asian FX markets are some 25% undervalued verus the euro, up from about 12% in mid-2007. In recent months, export growth to European nations out of Asia have accelerated, which also provides fundamental backing to the short euro/yen concept. 

A big story in the United States of late has been commodity price inflation and a spike in food costs, which is a double whammy to the U.S. consumer and has played a role in keeping our economy in check. When I was working briefly in Japan back in 1990, I had personal confirmation of the $8 orange juice, $100 per pound Kobe beef price horror stories, so it's not as if Japanese consumers are immune to high food costs (granted my prices were further inflated by a soft dollar back in that time frame). That said, there has been a renewed food price spike in Asia, and inflation concerns tied to higher prices should keep monetary policy on a tight hold, which is supportive for the currencies. 

Let me say right now that I am no economist. I don't predict inflation targets for the U.S. economy and I certainly don't forecast trade surplus figures for Japan - much less any of their obscure trading partners in the Pacific Rim region. What I do like to do is to find a trade opportunity with attractive potential, reasonable risk and reward parameters and an interesting story. For me, that starts with an examination of the chart structure, which is the most powerful representation of supply, demand and psychology that we'll ever get our hands on. 

For euro/yen, the market has been moving in sideways fashion since a stunning peak, collapse, and recovery move that was triggered back in July 2007 to August 2007. At that time, this cross entered a freefall from a record high in late July of 169.04 to a trough in August at 149.27. Within weeks, euro/yen was back at 167 and has been trading sideways-to-lower ever since. Extreme volatility at or near record highs is often a leading indicator of a coming sea change and that clearly was the case for this currency cross. When we look at a weekly chart for euro/yen, the market has struggled now on a few occasions to pop back through trendline resistance off that July 2007 peak, and if the euro is poised for a deep pullback here and the Asian fundamentals are undervalued, then a slide in the euro/yen would be no surprise. Risk on the trade is nicely defined by a breach of the trendline, and initial downside targets are at 155, then at 151 if support at 160 can be cracked. Ideal entry for the trade is around 161.50, while aggressive traders could consider entering here near 160.80.

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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