The euro finds support as sentiment plummets

I was away last week and since I last wrote, markets have given us some impressive moves, proving that a week is a long time in finance – and sometimes, conditions can change even in one day. In fact, last Thursday was just such an occasion when it was all-change in the currency markets with the US dollar suddenly reversing its bull run.

In my last post on the euro on 26 February, I flagged this dollar decline as a high probability event.

And with the avidly-anticipated European Central Bank (ECB) meeting looming on 10 March, where boss Mario Draghi is fully expected to crank up the ‘stimulus’ machine of more quantitative easing (QE) money-printing and even lower the policy interest rate further into negative territory. That was the overwhelming consensus view – and one I was likely to challenge.

I had been tracking EUR/USD down off its major top at 1.1360 on 11 February and was looking for a turn. I had identified a likely minor low with the hit on the meeting of the tramline and the Fibonacci 62% support level. Here is the chart I showed:

EUR/USD spread betting chart

The market was also entering chart congestion from the December-January period which I expected to provide some support. That area was a good place to take at least partial profits on short trades, as I pointed out.

But the decline had not stopped there with the market moving lower to break my lower pink tramline to take it deeper into the congestion zone. It was then that I sensed that the inevitable rebound was going to be sharp. The selling had to be intense to take the market well below my pink tramline – with an associated increase in short bets placed by speculators (which would be revealed by the latest Commitments of traders (COT) data).

Sure enough, that is precisely what the COT data shows. This is the snapshot as of last Tuesday (only released on Friday) – two days before the fateful snap-back rally:

Non-commercial Commercial Total Non-reportable positions
long short spreads long short long short long short
(Contracts of EUR 125,000) Open interest: 503,904
Commitments
105,765 165,932 57,339 291,418 212,752 454,522 436,023 49,383 67,882
Changes from 02/23/16 (Change in open interest: 6,180)
-3,445 20,704 5,100 7,472 -27,696 9,126 -1,892 -2,946 8,072
Percent of open in terest for each category of traders
21.0 32.9 11.4 57.8 42.2 90.2 86.5 9.8 13.5
Number of traders in each category (Total traders: 241)
65 96 69 57 60 159 188

 

Both hedge funds (non-commercials) and small traders (non-reportables) massively increased their short bets in the previous week (while the smart money commercials took the other side of that bet). The bear trap had been sprung.

And this is the result – here is the updated hourly chart:

EUR/USD spread betting chart

With a huge momentum divergence forming last week, the market broke cleanly above my blue trendline on Thursday and rocketed up in a massive short squeeze for a 200-pip two-day gain. Short-term traders were delighted.

But on Friday, the market hit major resistance with a traditional tramline kiss which also was the Fibonacci 38% resistance level.

So this morning, the shorts must be wondering what happened – and is their assumption that Draghi will serve to drive the euro lower on Thursday still valid, even though a ‘stimulus’ package may well be unveiled?

There is little doubt that much of the selling off the 1.1360 high was done by traders who took the party line that whenever central banks engage in “stimulus”, it must weaken the currency (that is their intent, after all). In four days, this theory will be put to the test (again).

But the omens are not good. In January, Japan unleashed its historic stimulus and drove its policy rate into the negative for the first time ever. And what did the yen do? It rose strongly in the following weeks. That was a great example of a “buy the rumour, sell the news” trade – and was contrary to received “wisdom”.

But has last week’s sharp euro rally changed the immediate outlook? Here is a close-up of the hourly:

EUR/USD spread betting chart

In fact, the rally possesses a classic five up with a long and strong wave 3, a fifth wave to new highs (which itself contains a nice five up), and a momentum divergence at the wave 5 high. This is entirely textbook – and heralds a major change in direction.

And if the textbook examples are to be maintained, I expect a pull-back in an A-B-C form to take the market to at least into the marked orange zone, which is the region of the wave 4 low (a common target for A-B-C pull-backs).

One of the major advantages of using the Elliott wave theory is that it offers a high probability roadmap for the market to follow in all time scales. Here, I have shown that the new five up, which usually signals a change of trend when it appears after a lengthy decline, is hinting that the new trend for the euro is up.

But at least until Thursday, the market will remain highly volatile.