My Favorite Setup: EUR/GBP

May 5, 2010

EUR/GBP has sold off quite aggressively this week and I think there is still downside opportunity for this currency pair!

On the euro front, the outcome of tomorrow’s ECB meeting is likely to be euro bearish. There is no question that rates will be left unchanged and ECB President Trichet will not consciously say anything to drive up the euro. Even though the slide in the euro has been aggressive, central banks usually become more concerned about a rising currency than a falling one. With inflation nonexistent, a weaker euro will help to offset the consequences of fiscal austerity measures being implemented across Europe. Avoiding any comments to support the euro is the minimum that I expect from the ECB tomorrow. Their priority right now is to stabilize the financial markets, provide funding for countries having difficult time raising money in the market and to prevent a further downturn in growth when fiscal austerity measures are implemented. Since investors are behaving as if the European debt crisis is growing more severe by the minute, the ECB may be forced to take the “nuclear option” of reinstating some of their long term funding facilities or worse, purchase Greek bonds.

On the pound front, I expect a relief rally after tomorrow’s elections. The Conservatives continue to lead and based upon the opinion polls, there will be no majority. So it is time to look beyond elections and over to the outlook for the U.K. economy and based upon the latest economic reports, the recovery is on track. In the month of March, construction sector PMI expanded by the fastest pace since September 2007. This of course follows the manufacturing PMI report which hit a 3 year high last month. If tomorrow’s service sector PMI report is strong as well, the Bank of England can officially draw a close to their Quantitative Easing program.

As a result, I think EUR/GBP will test both the support levels in the following chart:

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