In the volatile world of currencies it always pays to grasp the big picture. Regardless of your trading horizon, it is best to determine the long-term trend before you proceed. It also is important to understand what both the fundamentals and technicals are telling you. Looking at a monthly chart is the best way to grasp the evolving cycles. This approach works with all pairs, but let’s focus on the largest, EUR/USD.
We start with the fundamental interpretation of the monthly chart. "Driving Miss euro" shows that each of the three cyclical rallies were driven by a combination of U.S. Federal Reserve easing and/or European Central Bank (ECB) tightening. Without QE1 in 2009 and QE2 in Q4 2010, EUR/USD may not have rallied at the expense of the Fed-damaged dollar. Since the second round of quantitative easing (QE2) ended in June, EUR/USD struggled in a downward pattern of lower highs. Euro technicals could deteriorate if the Fed does not offset any euro damage (from Eurozone-debt) via aggressive easing. QE3 may be inevitable, but not on the scale of previous programs, in which case EUR/USD could sustain further losses.
Those betting on further quantitative easing imagine a rising U.S. dollar against the euro. The Fed stated that rates would remain near zero at least until mid-2013, but it is premature to interpret that as a downward spiral for the dollar. Both the euro and British pound are governed by central banks getting closer to their own version of quantitative easing. The Bank of England already has downgraded its 2011 forecasts for GDP growth and inflation.
What about the ECB? ECB chief Jean Claude Trichet already ruled out fresh tightening at the August press conference, which is a dovish development for the euro. We also must realize that the ECB has no choice but to step up its securities market program (SMP) of purchasing sovereign Eurozone bonds to dampen their soaring yields. Remember, it was in May 2010 when the ECB was forced to go against its long-held opposition to buying sovereign debt and snapped up Greek bonds. Since then, the bank has bought approximately €75 billion in Greek, Portuguese and Irish bonds. The sum amounts to about 15% of all outstanding bonds issued by those nations. But what will the ECB do if it has to buy a similar amount of outstanding Italian and Spanish debt, the sum of which stands at around €2.25 trillion? The ECB would have to shell out more than €300 billion just to hold a similar share and stabilize the corroded Italian and Spanish paper. If the ECB were forced to buy such an amount and inject so much liquidity, currency markets would deem this as massive easing and punish the euro. This leaves us to conclude that the medium-term fundamental outlook in EUR/USD is weak.
The bearish pattern of lower monthly highs and lower lows since 2008 is evident and the similarity of the duration of the two down-cycles also cannot be ignored. The post-2008 high down-cycle lasted eight months (July 2008 to March 2009), while the 2010 down-cycle lasted seven months (December 2009 to June 2010). If we were to use May 2011 as the start of the current monthly downtrend, then these declines will last through year-end. If the downtrend is to duplicate the 20% losses in the preceding two cycles, then a 1.17-1.16 target could be reached by January.
For the downtrend to gain momentum, EUR/USD must break below the all-important 200-week moving average, currently around $1.4020. This key average has acted successfully as support in March, May and July 2011. Once the 200-week moving average is taken out, the 200-day moving average, currently around $1.3940, comes next, which last was broken in January of this year. Finally, the most important support stands at $1.37. From a momentum stance, the monthly stochastics at the bottom of the chart indicate we may be in the process of falling back to the lows of winter-2009 and spring-2010.
Considering the latest bond shopping spree of the ECB and damaging dynamics in Eurozone debt, the euro shall remain vulnerable to breaking near the all-important support of $1.37. A breach below $1.37, would then open the door for 1.26, followed by the final target of $1.17.
While not every currency pair offers such a clear pattern, you should plot out what the markets are showing you before committing capital.
Ashraf Laidi is an independent strategist and author of "Currency Trading and Intermarket Analysis." His analysis appears daily on AshrafLaidi.com.