Navigate Upcoming EUR/USD Volatility

09/27/2011 6:00 am EST

Focus: FOREX

News events and a developing technical pattern for EUR/USD look likely to produce heightened volatility and continued downward price pressure in the near term, but also some potential short set-ups.

The euro/US dollar currency pair (EUR/USD) has dropped to its lowest level since January, and still, lower prices look likely in the near term. Consolidation since last Thursday may be taking the form of a triangle pattern on the chart.

chart
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In fact, completion of a corrective pattern and subsequent drop to a new low would compose five waves lower from 1.3935.

A downside level to keep in mind is the mid-January pivot at 1.3243. Strategically, I like shorting any bounces within the consolidation with a stop above 1.3566 and objective in the mid-1.3200 area. We should then have an opportunity to play an early-October reversal.

On the fundamental side, European Central Bank (ECB) board member Ewald Nowotny floated the idea of scaling back the benchmark interest rate from 1.50% but went on to say that the ECB shouldn’t “expand its toolkit beyond its current scope” during an interview with Market News International.

However, there’s speculation that the ECB Governing Council may vote on re-establishing its covered-bond purchases at the next policy meeting on October 6, and the central bank may employ a range of tools to shore up the ailing economy while the outlook for growth and inflation deteriorates.

According to Credit Suisse overnight index swaps, market participants are pricing in a 50-basis-point rate cut for the following month, and speculation for lower borrowing costs reinforce a bearish outlook for the single currency as policymakers struggle to restore investor confidence.

In turn, we are likely to see the EUR/USD trade heavy over the near term, and the pair may threaten the rebound from the beginning of the year (1.2873) as fears surrounding the sovereign debt crisis curbs risk-taking behavior.

See related: Forex “Risk-Off” Trade Is Back on

However, as the relative strength index (RSI) bounces back from oversold territory, the technicals foreshadow a near-term correction on the horizon, and we may see the EUR/USD turn higher before it resumes the sharp selloff carried over from August.

The clear caveat remains volatility itself. Traders should trade with reduced leverage on the real risk that markets will quickly reverse and potentially force large trading losses. This is especially true for Japanese yen (JPY) pairs amidst heightened risk of Bank of Japan/Ministry of Finance forex market intervention.

Traders should monitor risk closely and keep leverage low despite the relative attractiveness of certain trading systems.

Our DailyFX volatility indices are now near their highest levels since the height of the financial crisis in late 2008. Indeed, a glance at their recent patterns shows a trend of higher highs and lower lows. Markets are increasingly positioned for sharp moves, and such conditions warn aggressively against low-volatility range-trading systems until further notice.

By the Staff at DailyFX.com

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