Euro: Looking for an Upside Breakout

July 26, 2010

The European stress tests are now behind us and unfortunately they failed to be the buzz kill or euphoric event that was needed to break the EUR/USD out of its recent trading range. The goal of the stress tests was to restore confidence in the European banking sector, but based upon the price action in the currency and European equity markets this morning, investors were not impressed. The results scream leniency because all of the big European banks passed and those that failed were either very weak to begin with or already expected to do so. There will be no major capital injections into banks, which was what followed the U.S. stress tests and was instrumental in rebuilding confidence in U.S. banks.

Despite some intraday volatility on Friday, the EUR/USD has been virtually unchanged since Thursday. Yet the formation in the charts tell us that the currency pair is prime for a breakout. The 1.30 resistance and 1.28 support levels probably won’t hold for long even as we head into August, when the doldrums of summer are at their highest. Based upon the price action and the prospect of stronger European, weaker U.S. data this week, I believe that the breakout will be to the upside. It should be just a matter of time before the EUR/USD breaks the 1.30 level, paving the way for further gains.

EUR/USD Daily Chart

Can we Trust the Stress Test Results?

The 600 million dollar question is whether or not we can trust the stress test results. Excluding the risk of a sovereign default immediately undermined the credibility of the results as earlier this year many people in market were convinced that Greece would default on their debt. Also having such a small amount of banks fail the tests screams leniency. By only evaluating the bonds on the trading books and not those held to maturity, the tests ignored a large amount of debt on the balance sheets of banks which will receive significant backlash and criticism. The stress tests may have been modeled off the U.S. tests, but the credibility pales in comparison. When the U.S. conducted its tests, 10 out of 19 banks failed. By passing more than 90 percent of the banks, the EU did not require them to boost their rainy day fund, which in the long run would have been good. More than 50 percent of the failing banks were in Spain which could also increase focus on the country’s risks. However the Bank of Spain has a restructuring fund in place to provide support for capital shortfalls. There is no question that the results were not as tough as the market had hoped, but the event risk that the market had been obsessing over for the past month are now behind us.

Posted in 2010 eurusd forecasts, euro, forex blog