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Euro Poised for Breakdown, but Timing Eludes Us – Time for Plan B

By , Quantitative Strategist
17 August 2012 23:28 GMT
Euro_Poised_for_Breakdow_but_Timing_Eludes_Us_Time_for_Plan_B_body_Picture_5.png, Euro Poised for Breakdown, but Timing Eludes Us – Time for Plan B

Fundamental Forecast for the Euro: Bearish

The Euro finished the week almost exactly where it began, and traders expect extremely quiet price action to continue through the days ahead. A relatively quiet week for economic event risk leaves all eyes on the US Federal Reserve as traders try to time the next jump in financial market volatility.

FX Options traders are betting on the smallest 7-day Euro/US Dollar volatility in five years, but what could force the slow-moving EURUSD pair out of its recent trading range? A relatively empty European economic calendar leaves little reason to expect the catalyst for a major break will come from the continent. Across the Atlantic, however, the release of the minutes from the most recent US Federal Open Market Committee meeting could stir speculation for the US central bank’s next monetary policy moves.

Given heightened speculation surrounding the future of the Fed’s Quantitative Easing measures (QE3), all US Dollar pairs could see big swings on surprises in FOMC minutes. Surprisingly strong US Nonfarm Payrolls data for July tempered speculation that QE3 was imminent, and indeed the official statement from the Fed’s most recent meeting showed little change in stance. Yet Fed officials are most often more candid in their assessments of economic risks and the likelihood of fresh policy action in FOMC minutes. Any significant surprises could force the US Dollar (ticker: USDOLLAR) to move in kind.

It is certainly tempting to claim that the Euro set a significant top at the $1.2440 mark and could break substantially lower in coming week. Yet we’re big believers in FX market seasonality, and the fact that the Euro/US Dollar continues to move in a progressively narrower trading range through August suggests we may need to wait until September for the next big moves.

In the meantime, our studies show low-volatility range trading strategies have historically done well in quiet market conditions. For the Euro/US dollar, this implies that any sharp rallies may be sold and noteworthy declines bought. Similar data show that more aggressive breakout trading strategies—buying high and selling higher or selling low to buy lower—have historically done well as markets turn more volatile. Given that the Euro/US Dollar remains in a fairly clear downtrend, we would favor selling a Euro break lower. Before that happens, however, we will need to see a significant jump in volatility expectations as that would increase the likelihood of continuation lower.

September is still two weeks away, but the coming month may promise larger currency swings on several highly-anticipated dates on the calendar. For the Euro, all eyes turn to the German Constitutional Court as it rules on the legality of the European Stability Mechanism (ESM). If the ESM is deemed unconstitutional according to German law, it would likely spell the end of the critical bailout mechanism and arguably the most viable solution to ongoing regional fiscal crises. September likewise promises a contentious US Federal Reserve interest rate decision, and the coming week’s FOMC minutes may go a long way in setting expectations for US monetary policy.

It’s difficult to predict exactly when currency markets could finally see volatility as trading ranges fall to their lowest in five years. Given obvious macroeconomic risks to the Euro Zone, we get the sense that the Euro itself is one catalyst away from the next substantial move lower. Of course—timing is the only thing that matters in trading. And frankly, timing a EURUSD breakdown has eluded us for some time now. We see little choice but to wait and see when the market proves willing to force big FX moves. We’ll look to sell any significant Euro bounces and buy any sharp declines in the interim. – DR

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.
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17 August 2012 23:28 GMT