Euro gets hit hard to start a new year of trading

After a brief rally at the start of this holiday-shortened week, the EUR went on a largely one-way trip south, resuming its year-end decline against all major currencies. 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 10-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 ECB rather than lend to peers, signs that high levels of mistrust remain within EU banking circles despite the ECB’s new LTRO’s 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 Nov. retail sales and factory orders both falling more than expected (-0.9% MoM vs. exp. +0.2%; -4.8% MoM vs. exp. -1.8%, respectively). In short, 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 EUR-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.

Still, we are approaching some potentially significant levels of support in EUR/USD a bit lower at 1.2600/50, which is the 76.4% retracement of the 1.1880-1.4940 advance (1.2601) and a series of intra-day lows from dating back to Aug./Sept. 2010. The US dollar index (last 81.25) is also within reach of key daily highs from late Nov. 2010./early Jan. 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 1.2840/80 area as the potential trigger to a short-squeeze and a correction higher.

Next page: What to expect out of Europe next week

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