The Forex Trading Week Ahead

The euro's rebound following the announcement of the EU rescue package proved exceptionally short-lived. Markets immediately smelled blood and added to EUR shorts, driving EUR/USD below additional key technical levels, most notably the 1.2450/1.2500 2009 lows, which now serve as the critical daily closing resistance zone. However, the past week's decline came up short of the 2008 lows at 1.2330, and this level will act as the next trigger to further declines. In the midst of this EUR weakness, we are starting to get the feeling that euro bearishness is reaching extreme levels. That does not mean that the EUR won't see lower in the week ahead; in fact, we anticipate further declines to the 1.2150/1.2200 area in the short run (based on an Elliot Wave count), but from there, the likelihood of a base/correction forming increases greatly.

In addition to anecdotal evidence ("Business Week effect," i.e. financial media's intensity of reporting on EUR's imminent demise; analysts' forecasting declines through parity; rumors of EMU disintegration), the relative suddenness of the EUR's decline (6+% in two weeks) means that many “real money” asset managers have yet to establish short EUR positions. This group is typically among the last to arrive at the party and frequently signals medium-term tops and bottoms. More concretely, one month EUR 25-delta risk reversals (RR's) (option market measure of puts/calls bias) have hit extreme bearish levels (see chart) last seen at the height of the Lehman Bros. financial market meltdown (see chart). (GBP shows similar extremes) In fact, following the announcement of the ECB debt backstop, RR's bounced sharply and failed to make new lows even as spot prices extended losses. This divergence is mirrored in peripheral European debt yields, which have dropped back sharply on ECB bond buying and have ignored market commentator's predictions of a Greek default.

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EU/ECB Won't Give Up Without a Fight

The ECB's debt backstop should not be underestimated as it effectively removes the risk of a sovereign debt default over the next several years, potentially providing another basis for a EUR rebound in the near term. As well, EU officials were compelled to take this drastic measure in defense of the EUR as its decline threatened to become disorderly and disrupt the economic recovery. EU/ECB officials are certainly not pleased with the continued EUR weakness based on lingering credit/deficit concerns. We expect additional verbal intervention to try to stabilize the EUR when EU finance ministers gather in Brussels on Monday and Tuesday. Additional sharp declines in the euro will put us on alert for potential direct market intervention, but for now, we think stealthy intervention via the BIS will be used to smooth the EUR's slide. While EUR/USD holds below 1.2450/2500 on a daily closing basis, we would remain sellers, but we would be willing to venture EUR/USD longs on weakness into the 1.2150/2200 area for a potential correction.

Again, this is a multi-week, tactical trading view. On a longer-term basis, we fully expect euro zone economic underperformance, interest rate differentials, and a structural re-pricing of the EUR to ultimately weigh on the common currency. Relative to the EUR's long run average of 1.17/18, the EUR remains on the strong side and this needs to change (see more below). If our expectation of a near-term stabilization in the euro materializes, we would then look for a correction into the 1.32/35 area later this summer as strategic opportunity to re-sell EUR on a longer-term view.

NEXT: Major Implications for EUR Set to Materialize Now

Risky Assets Have Dropped to More Attractive Levels

EUR weakness has translated into broad USD strength, and this has seen other currencies get caught up in the mix and drop to more attractive levels against the USD, in particular AUD and CAD. Given expected future interest rate increases and ongoing solid economic performance in those countries, we think this pullback offers an opportunity to get long AUD/USD in the 0.8750/8850 area and short USD/CAD between 1.0350/1.0450. We would also note that the so-called “carry trades” (i.e. JPY crosses like AUD/JPY, NZD/JPY) have also seen sharp declines, but nowhere near the collapse seen on May 6. This too suggests the risk aversion stemming from EUR weakness is subsiding rather than intensifying, and we would consider short-term long risk positions in AUD/JPY, CAD/JPY, and maybe even GBP/JPY. In line with our view of a potential near-term base in the EUR, safe-haven demand for gold may diminish if EUR stabilizes, and here, too, a potential double top at $1250/oz suggests that the currency-related panic may have crested.

Concerns Over Fiscal Coherence in EMU Will Drive EUR Lower Longer Term

The EU's huge EUR750-billion support package was designed to chase away any threat that an EMU member nation would default on its debt. The EUR's relief rally, however, lasted less than 24 hours. EUR440 billion of this fund is due to come from member nations with Germany being the largest contributor. While the German government has signed on to the plan, there are clear signs that the German taxpayer is unhappy of the notion of a “transfer fund.” This may imply that EMU's sovereign states may not be ready to tolerate the closer fiscal ties and reduced fiscal autonomy that may be necessary to oil the wheels of monetary union. That said, the fiscal tensions of the EMU could be ironed out if the worst-performing members could bring their competitiveness in line with Germany's. The market is highly skeptical that Greece, Portugal, Spain, and Ireland will be able to implement the budget reform necessary for this internal devaluation. Yet, in recent days, both Spain and Portugal have announced additional drastic budget measures including public sector wage cuts. This is movement in the right direction, but investors have not been encouraged. If fiscal prudence is not restored across the EMU, and if any one of the EMU's sovereign states simultaneously blocks cross-border fiscal support, Greece would almost certainly have to default on its debt. In view of these concerns, the EUR is likely to remain under pressure against the board. As investors come to terms with the risk that economic growth will be pressured by fiscal repair in countries across the industrial world, the USD is likely to be supported by safe-haven demand. EUR/USD may be headed to its long-term average of 1.18.

In the coming days, the ECB is expected to announce details of how it will sterilize its purchases of government debt. Comments from ECB president Trichet suggest they may use interest bearing term deposits as the primary means. The ECB this week bought bonds of Ireland, Greece, Portugal, and Spain in maturities of up to ten years. The ECB has maintained that its bond purchases will not fuel inflation. This claim is supported by the likelihood that euro zone growth will struggle to climb much more than 1% this year. The ECB's Stark has hinted the ECB may hold the debt until it matures.

EUR/GBP: A Better Medium to Express a Constructive View on the Pound

The outlook of sterling assets continues to depend very much on the performance of the new UK government in the area of deficit reduction. A budget has been promised on the 50th day of the government's term, and news that ministers have kicked off the deficit-reduction process by taking a 5% pay cut continues the theme that progress could be made fairly rapidly. A strong USD on the back of safe haven demand could make it difficult for cable to make much headway in the coming months, suggesting that any gains for sterling are likely to be much more visible versus the EUR. The 2009 low of EUR/GBP 0.84000 remains an important technical target, and a move below could be the harbinger of a more significant move lower.

By Brian Dolan, chief currency strategist, FOREX.com