The Forex Trading Week Ahead

Global headwinds and bad news and data out of the Eurozone give plenty of reasons to short the euro, but not even the US dollar and apparent recovery in the US are immune to the stresses.

After a brief rally at the start of last week’s holiday-shortened trading week, the euro (EUR) went on a largely one-way trip south, resuming its year-end decline against all major currencies. European Union (EU) sovereign debt fears and banking sector stresses continue to send investors fleeing from the Eurozone.

Government bond yields of the most troubled EU economies surged, with Italian ten-year yields finishing out the week at 7.07% and Spain’s at 5.63%. EU banks continued to park record amounts of cash at the European Central Bank (ECB) rather than lend to peers, a sign that high levels of mistrust remain within EU banking circles despite the ECB’s new longer-term refinancing operations (LTROs) in late December.

Fears of impending credit rating downgrades later this month also weighed on sentiment for the single currency. EU economic data did not help either, with German November retail sales and factory orders both falling more than expected (-0.9% month-over-month (MoM) vs. expected+0.2%; -4.8% MoM vs. expected -1.8%, respectively).

In short, there are more than a few reasons to sell the single currency. Also, we would note that recent correlations between EUR and other assets (e.g. positive EUR/USD and S&P 500 relationship) have weakened or even inverted in the past week, reinforcing our view that this is a euro-centric move.

The euro’s declines have become stretched according to some technical measures and we will be on high alert for short squeezes in the week ahead, especially in light of EUR-era record short positioning, according to the latest CFTC data. (EUR weakness on the crosses (e.g. EUR/AUD) has also been especially pronounced, potentially adding fuel to a short-squeeze fire.)

EUR/USD is currently trading below the lower Bollinger band (last at 1.2798), which has frequently seen prices bounce back for a few days at the minimum. Daily RSI levels are approaching oversold territory, which has also signaled rebounds in recent months. In terms of price action, however, we see no sign of a bounce, as prices have finished out the last three days nearer to their lows.

See related: Trading Forex with Bollinger Bands

Still, we are approaching some potentially significant levels of support in EUR/USD a bit lower at 1.2600/1.2650, which is the 76.4% retracement of the 1.1880-1.4940 advance (1.2601) and a series of intraday lows dating back to August/September 2010.

The US dollar index (last 81.25) is also within reach of key daily highs from late November 2010/early January 2011 at 81.33-81.45, which could serve as an interim milepost. As the saying goes, “The trend is your friend,” which suggests a short bias until key resistance levels are breached. There, we would focus on the 1.2840/1.2880 area as the potential trigger to a short squeeze and correction higher.

NEXT: Key Euro Events to Watch This Week

Key Events Out of Europe This Week

When it comes to fundamental catalysts that could trigger a EUR rebound, there are several (scheduled) events on tap this week that could provide a spark, but mostly we see more EUR downside risk from them.

First up is a press briefing by Merkel and Sarkozy on Monday around 1230GMT following private talks. We don’t expect any new initiatives addressing the debt crisis to come from the duo, but instead for them to finalize the details of the debt-stabilization pact agreed upon in December and to otherwise address topics for the January 30 EU summit (Iran sanctions, financial transactions tax, etc.).

If Chancellor Merkel reiterates her steadfast opposition to using the ECB as the lender of last resort or enlarging the size of bailout funds, EUR could take that badly.
Thursday sees the first ECB meeting of 2012, and the vast majority of economists expect no change to ECB policy or rates. However, we think there is a non-trivial chance that the ECB may cut rates another 25 basis points (bps) to 0.75%. That raises the question of how much EUR selling this past week was the pricing in of a possible ECB rate cut?

If they don’t cut, does that prompt a short squeeze? If they do cut, how much more downside is available? Our crystal ball can’t see the answer clearly, so we will rely on the price levels outlined above.

Also on Thursday, Fitch Ratings is expected to announce its outlook for EU sovereign credit ratings, which we don’t expect to be a happy time for Eurozone bond markets, banks, or the single currency.

US Continues to Outperform, But Clouds Loom

Recent US data has continued to reinforce the notion that the US recovery is continuing, possibly even strengthening somewhat. But major headwinds remain for the US recovery (depressed housing, still high unemployment, and fiscal drags, to name a few). Despite the rosier data picture, however, the Economic Cycle Research Institute’s (ECRI) weekly leading indicator (WLI) dipped further to -8.2 from -7.6, supporting ECRI’s earlier call that the US was facing renewed recession prospects in the months ahead.

While the ECRI’s WLI view is controversial, we think it’s worth keeping in mind. Our own view is that the US is not immune from the headwinds buffeting the rest of the global economy, and here we see further reason for caution on risk assets in general.

Earlier this week, China’s 4Q Business Climate Index fell sharply from 133.4 to 128.2 and the 4Q Entrepreneurs Confidence Index slumped from 129.4 to 122.0, indicating that China still faces risks of a harder landing.

Eurozone data continues to point to recession, and the latest numbers out of Germany, the ostensibly strong economy, are not encouraging. Japan has also likely relapsed into recession in 4Q.

Against this backdrop, we are not optimistic that the US recovery is as robust as many seem to believe, and we remain watchful for backsliding in US data in the months ahead. Our bias, then, is to selectively use strength in risk assets as opportunities to enter short positions and to use USD pullbacks as long-entry opportunities.

By Brian Dolan, chief currency strategist, FOREX.com