Why this Could be a Temporary Bottom for the US Dollar and the Beginning of More Losses for the Euro

April 28, 2008

After hitting a high above 1.60, the EUR/USD has fallen over 400 pips. The failure to extend far beyond 1.60 should not be all that surprising if you have been following my posts. Last Tuesday, when the Euro broke 1.60, I pointed out that the lack of major option barriers above 1.60 suggested that
“the power of the move above 1.60 will not be as strong as the move above 1.50. In fact, 1.60 could even be a near term top.”

On April 23, I even said that EUR/JPY was ready for a top after rallying for 7 consecutive trading days. Since then, the currency pair has fallen over 150 pips and now looks prime for further losses.

3 Reasons Why the Euro Could Fall Further

There are 3 major reasons why I think this could be a temporary bottom for the US dollar and the beginning of more losses for the Euro:

1. Federal Reserve Could Pause

According to the table below, not only is the market growing increasingly confident that the Federal Reserve will only cut interest rates by 25bp on Wednesday, but they also believe that the Fed will pause. Although no comments have been made over the past few weeks by Fed officials to specifically suggest this, the continual rise in oil, steel and rice prices has everyone guessing that inflationary pressures may force Bernanke to start taking tips from former Fed Chairman Volcker fought double digit inflation rates with interest rates as high as 20 percent.

Although I think that 25bp is all that we will get from the Federal Reserve, they may be reluctant to pause as non-farm payrolls is expected to fall for the fourth month in a row.

Will the Federal Reserve be willing to put the economy at risk? That is the question that they will have to answer on Wednesday.

2. Speculative Positions in Euro Flips for the First Time Since 2006

One of the indicators that I watch very closely is the FXCM Speculative Sentiment Index. It is a contrarian indicator that measures the positioning of the company’s most speculative clients. The whole idea behind the index is that this subset of top pickers and bottom fishers are consistently on the wrong side of the market. The chart below indicates that their positions flipped from net long to net short in 2006 and has remained net short for over a year. Throughout this time, the EUR/USD rallied from 1.25 to a high of 1.60.

For the first time since 2006, the index has flipped into positive territory, which gives us a VERY strong sell signal. Therefore based upon sentiment, we are ooking forward to more losses.

3. EUR/USD in Sell Zone

My favorite technical indicators are Bollinger Bands. In the following eSignal chart, I have laid on the 1st and 2nd standard deviation Bollinger Bands. As a rule of thumb, if price is within the 1-2 BB on the topside, it is in what I call the Buy Zone. If it is in the 1-2 BB on the downside, it is in the sell zone. Last Thursday, the EUR/USD entered into the sell zone. As long as it does not close above the 1st standard deviation BB on the downside, there is scope for further losses in the EUR/USD.

These three factors could all be validated by a simple comment from the Federal Reserve. If they satisfy the market on Wednesday by toning down their FOMC statement and signaling a pause, fundamentals, sentiment and technicals will all line up to support further losses in the Euro.

Posted in Bernanke, ECB, FOMC, Fed Rate Cut, Fed Rate Cut Expectations, Federal Reserve, Inflation, US Dollar, US Economy, Wall Street Journal, euro, non-farm payrolls