10/12/08 12:02 pm - EURUSD:G7 emergency measures may provide support

Wow. What a week. Let’s step back and take a look at the long, medium, and short term outlook for the Euro/Dollar pair.

Long Term Outlook

The dollar benefited from the collapsing markets last week and drove the Euro to new lows. EURUSD broke through major support at 1.3319 (38.2% Fibo of the daily range), but managed to close above it. The weekly long term trendline is now clearly broken and the weekly charts look quite bearish. Euro bulls can still cling to Fibo38 support, however.

Despite the bearish technicals, my long term outlook is still bullish, mostly anchored in fundamentals. First, I believe that the main reason for recent dollar strength is the deleveraging of the markets in times of highly restricted liquidity. This has led to the crash this week as market players scrambled to meet margin calls and to fund other obligations. I don’t think it is so much that the dollar is perceived as safe haven, that’s probably true only to some extend.

Second, there is the bailout and the prospect for rapidly accelerating inflation. I think it’s too early to use the word “hyper inflation”, but we could very well see that happening. Europe has its own problems and is adopting now national bailout plans as well, but the exposure to US mortgage derivatives is still smaller compared to US banks. This inflation scenario should be in favor of the Euro in the medium and long term, as well as gold and commodities. We are now in a very short period of deflation, that is likely followed by high inflation.

And finally there is the interest rate differential. Once the dust of the crash has settled a bit, we should see traders make more rational decisions based on fundamentals again, and this should be in support of the Euro.

My big-picture long-term outlook at this point: I am bearish on the dollar and US general stocks (Dow, S&P, NASDAQ), and bullish on the Euro, gold, gold stocks, and oil. We are in a commodities bull market that started in 2001 and is likely going to continue for another 5 years at least.

Medium Term Outlook

Today, several European governments announced emergency measures to protect banks and depositors. This will likely the be perceived positively by the stock markets, and should also lift the Euro. The daily RSI chart shows now signs of a decreasing downside momentum, and is in oversold territory. The daily decline form the all time high at 1.6036 down to 1.3256 looks complete and has the characteristics of a typical bear leg. It started with a breakdown through support at 1.5383 and a sharp down move to 1.4646 that covers 50% of the entire leg (Fibo50).  This is followed by a measured decline (here to 1.3881), and the first strong corrective upleg (1.3881 to 1.4865) where the early bulls are getting hopeful. The bear leg is completed by a capitulation move to new lows, which I originally thought was 1.3442, but may now end up being 1.3256, or even lower if the stock markets continue their decline next week. But strong support at 1.3319 should limit further down side in the short term and is in favor of a rebound.

The bear leg chart pattern I just described can be observed in hourly charts as well, and is rooted in the psychology of market participants (greed/hope and fear). It applies to bull legs in reverse as well. A bull leg often starts with an accelerating exponential move, a brief pull back, a measured upmove, a deep correction, and is completed by an exponential blow-off phase.

Short Term Outlook

The short term is difficult to predict at this point, but I favor further upside for the Euro based on the joint statements by the G7 nations to calm the financial markets. Very strong rebound of 200 points after hitting support at 1.3256 initially failed at 1.3458, which is good hourly resistance and the 38.2% Fibo retracement of the last hourly range. I expect the rebound to continue to at least Fibo50 at 1.3520. Next major resistance is the 1.3580..1.3610 area, and a break above would call for further upside to 1.38.

Alternatively, we could see an extension of the down move likely coupled with high volatility. Next major support is coming in at 1.2870, and we have to go back to Jan. ‘07 to find it.

Action Plan: I missed my chance to exit the long trade on the rebound after the channel breakout, and took a full stop loss of 132 points. Sidelined until a clear bottom pattern emerges. Risk/return too low for a short trade.

Support: 1.3256 L-10-10    1.2970 H-5-15-06    1.2870 WSpptRsst

Resistance: 1.3458 Fibo38 L-10-6    1.3520 Fibo50, HSpptRsst    1.36 HSpptRsst

RSI: Hrly: Capped by decl. TL, recovering from oversold, Dly: Supported by rising TL, potential FS

Hourly Chart: