The Euro has embarked upon a solid performance in the last week, running a 2018 record 6-day winning streak, which may lead to some misleading conclusions about an overly bullish outlook. What we are seeing in terms of price action and market structure qualifies as classic ‘bearish trend-friendly’ market dynamics as the exchange rate heads back up to retest the origin of the range breakout point. Remember that the resolution away from the 3-month 3c. range in Euro/US Dollar came amid one of the highest open interest increases we’ve seen this year, revealed by the latest CoT data. This piece of information constitutes a key insight that tells us the market runs the risk of remaining strongly short-side committed.
EUR/USD shows the rate revisiting the breakout point
Meanwhile, the daily volume tick data collected also suggests that while the transition lower through the 2nd week of August came on increasing volume (candles Aug 9, 10), the subsequent recovery is starting to taper off, an event that tends to lead towards a market reversal as the exhaustion of bids get overwhelmed by an imbalance of supply. Also note, the current recovery in the pair has been largely fueled by the broad-based long liquidation of US Dollars as bond tradersreturned in mase to own long-dated US bonds (10s and 30s), resulting on the benchmark yield spread against the German to squeeze rapidly from -2.57% to -2.47% in a matter of days. That appears to have assisted the most in fueling the Euro recovery.
However, the sharp deterioration in the risk-weighted index since Aug 7th cannot be shrugged off and looks set to be what eventually may pull the rug under the EUR feet. Whenever the market resorts to risk-off flows, we’ve seen how the Euro suffers as the inertia is for capital flows to flock back into the safety of the US Dollar. So, is the current risk profile in the market justifying that we are out of the woods and hence expect a further dumping of USDs? From the chart above, one can immediately notice the Euro is far overstretched when compared to the degree in which risk has come back up. Yields spreads, especially the 10-yr, are definitely arguing for an adjustment in the exchange rate, but with risk-off flows having predominantly been the leading short-term predictor on setting-up the tone in markets this August, one should be extremely wary that such dynamics won’t just go away, especially in the current stage of the macro risk profile we are in (stage 3: market distribution).
Should we see a further recovery in the exchange rate, overhead awaits a volume accumulation that has been over 3 months in the making around the 1.1650 area. It’s going to prove extremely hard to break through it with so much outstanding interest gathered to the downside on the latest technical breakout. If one adds into the picture the hefty levels of the Italian bond yields – a worry for the ECB -, together with a volatile economic situation in Turkey, the Lira, and the possible contagion effects in some European banks, the backdrop looks far from ideal. Note, this week’s long holiday in the country appears to have helped to exert a false sense of stability.
Overall, the temporary reprieve in US Dollar buying flows should be seen as limited in nature. While the benchmark yield spread has improved markedly, it is far from being the only predictor to estimate the potential direction. The concurrent biases in the amount of open interest committed to short bets in the Euro via the CoT report, a risk environment that remains fragile, a technical breakout retest structure still in play, and Italy and Turkey still at the epicentre of people’s mind are all elements that keep the risk skewed towards the EUR/USD bear trend to stay its course.