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Consequently, the path of least resistance suggests a weaker euro and a stronger dollar.

Over the past week or so we’ve looked at both the GBPUSD and USDJPY in the context of monetary policy meetings from the Bank of England (BoE) and Bank of Japan (BoJ). Now these meetings are behind us, as are those from the US Federal Reserve and European Central Bank (ECB), it’s worth considering the most heavily traded currency pair - the EURUSD. We can do this in terms of what we think we know about the likely timing and rate of future monetary tightening from the world’s two major central banks - the Fed and the ECB.

But first off, some background. If we look at the EURUSD chart below we can see that the euro rallied sharply over the first nine months of the year. The EURUSD rose from a 14-year low around 1.0350 to a two-year nine month high just below 1.2100 at the beginning of September. But the dollar has recovered since then and it’s possible that this could be a trend reversal rather than a corrective move. Technically, the EURUSD appears to have carved out a “head and shoulders” pattern as highlighted below. The “head-and-shoulders” is a reversal pattern which typically marks the end of an upward trend in a particular financial instrument. This ties in beautifully with what we already know about the EURUSD.

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The diagram above shows a head-and-shoulders top. The neckline is formed by drawing a line linking up the lows formed after the first shoulder and the subsequent head. Once the second (right hand) shoulder is formed, the neckline becomes a significant area of support. If the price breaks below here then there’s a strong possibility that prices will continue to decline. In other words, the head-and-shoulders pattern signals that the price action has reversed and is now heading downwards after previously trending up before forming the pattern. Now, it’s also important to measure the distance between the neckline and the top of the “head”. This is the pattern height and typically traders then anticipate prices falling by a similar amount below the neckline. If they do then this can be a place to buy back and book profits. However, it could be worth moving a stop down to just above the neckline in the hope of capitalising on an additional move downwards.

bub

We can see that the neckline comes in right on the 23.6% Fibonacci Retracement of the January-September rally. The EURUSD has broken below here (1.1680) suggesting that further downside is possible. As said before, technical analysts typically look for a downside move equal to the distance between the “head” and “neckline”. This is around 400 points (1.2100 minus 1.1700 roughly) suggesting a downside target of 1.1300 (1.1700 minus 400).

Fundamentally, the ECB has said it will extend its Asset Purchase Programme (APP) beyond next month’s cut-off. The bank will continue to purchase bonds, albeit at a rate of €30 billion per month rather than €60 billion. In addition, ECB President Mario Draghi explicitly said that the APP could be extended in size and/or duration in necessary. So this is a dovish outlook from the ECB. At the same time, the Fed has said nothing to reduce the likelihood of a 25 basis point rate hike next month. Consequently, the path of least resistance suggests a weaker euro and a stronger dollar. Of course, this isn’t exactly an earth-shattering secret so must be priced in already. So we now need to keep a close eye on economic data from both the US and Euro zone in case anything should blow either central bank off course.

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Posted by David Morrison

Tagged: FOMC ECB FED EURUSD EURO

Category: PM Bulletin


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