EUR/USD pain trade could bite twice

March 5, 2018 08:30 AM
Forex

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The “pain trade” refers to the tendency of markets to deliver the maximum amount of punishment to the most investors. In essence, a pain trade is when a major asset moves contrary to how the majority of traders believed it should have traded.

In 2017, the pain trade was no doubt being long the euro/U.S. dollar (EUR/USD) currency pair. After predictions of euro/U.S. dollar (EUR/USD) currency pair to parity failed in 2015 and 2016, market strategists were finally poised to collect on those bets as the combination of easy monetary policy in the Eurozone and an accelerating United States economy supported by a tightening Fed made it feel inevitable that the EUR/USD would hit 1.00. Someone should have told EUR/USD traders, who instead drove the world’s most widely traded currency pair up by 1,500 pips from near 1.05 to above 1.20 (see “Parity failure, below”).

Ever the wily bunch, strategists at the big banks seem to be saying “fool me once, shame on you; fool me twice, shame on me” when it comes to the EUR/USD. With a couple notable exceptions, the consensus on the street appears to be that the single currency will rise to 1.25 or 1.30 against the greenback by the end of the year, supported by accelerating economic growth in the Eurozone and an end to the European Central Bank’s (ECB) quantitative easing program. While that certainly is possible, there’s a risk that the pain trade strikes in the opposite direction in 2018.

When it comes to the EUR/USD, monetary policy divergence will be a key theme to watch in 2018. In December, the Federal Reserve increased interest rates for the fifth time in this cycle, and with a stable of more hawkish Fed governors rotating into voting positions, another three or even four rate hikes look likely in 2018. Meanwhile, the ECB is still several years behind the Fed’s normalization pace. Even if central bankers in Frankfurt do wind down asset purchases in September as currently planned, they still must navigate the region’s negative 0.40% deposit rate and potential loan forgiveness for Greece (again) later this year.

Fiscal policy, which has taken a back seat to monetary policy in recent years, also seems to favor the U.S. economy in the coming year. The passage of the GOP’s tax cut bill is likely to boost economic growth in the short term, and Republicans may push hard for an infrastructure spending initiative to juice the economy further ahead of what promise to be hotly-contested mid-term elections in November. Meanwhile, most of the countries in the Eurozone are sporting small deficits that are likely to shrink further in 2018. Indeed, Germany has run budget surpluses in four straight years. While this sort of fiscal restraint is more sustainable long term, it can hurt growth short term.

Finally, the CFTC’s Commitments of Traders (COT) report shows that large speculative traders are holding a record net long position in the euro, a polar opposite in sentiment toward currency relative to last year. While the majority of traders certainly can be right on a market’s direction for a period of time, such lopsided positioning is often seen at major market reversals.

From a technical perspective, the key levels to watch will be 1.21 and 1.16: if the EUR/USD can break and hold above key previous support/resistance at 1.21, the bullish momentum from last year could carry it into the mid-1.20s. On the other hand, a break below the Q4 low around 1.16 would suggest that the pain trade has kicked into reverse, opening the door for a move back toward 1.10 or lower.   

About the Author

Senior Technical Analyst for FaradayResearch. Matt has actively traded various financial instruments including stocks, options, and forex since 2005. Each day, he creates research reports focusing on technical analysis of the forex, equity, and commodity markets. In his research, he utilizes candlestick patterns, classic technical indicators, and Fibonacci analysis to predict market moves. Weller is a Chartered Market Technician (CMT) and a member of the Market Technicians Association.