Has the Euro rally just begun?
It wasn’t long ago the mass assumption of market analysts was the Euro and the dollar would trade at par in the very near future. Despite an overabundance of support for this theory, the mid-$1.04 area was the cheapest price the euro traded against the dollar in the March plunge. Nevertheless, that price didn’t last long; the euro traded below $1.05 only briefly. Since then, the European currency has traveled above $1.14 for the first time since February. Par wasn’t in the cards for the EUR/USD in the first quarter, but will it be later in the year? If history has any bearing, it probably won’t.
As the euro appreciates against the dollar, the bearish euro chatter is growing into a light roar. Widespread pessimism is implying the euro recovery has gotten “rich” and the downtrend toward par should resume sooner rather than later. However, if there is one thing we have learned about the currency markets, it’s that going with the masses can be a bad idea. Had you sold the euro in March during the anti-euro media frenzy, you would have paid dearly.
As painful as it has been for the shorts, we suspect things could get much worse for the euro bears. At the moment, we are seeing overly complacent bears in an inclining market, which could lead significantly more gains for the euro as the shorts are squeezed out of the market. If you are unfamiliar with the term “short squeeze”, it is “a situation in which a heavily shorted stock or commodity moves sharply higher, forcing more short sellers to close out their short positions and adding to the upward pressure on the market”, as borrowed from Investopedia. Simply put, during a short squeeze bearish traders are being “squeezed” out of their short futures positions, often at a loss. Thus, overcrowded trades are highly susceptible to this type of panic liquidation.
Although the recent rally feels substantial, it pales in comparison to the decline. It is also meager relative to the rallies that materialized after previous trend-line reversals. For example, in mid-2010 the euro reversed near $1.1850 and eventually traded to $1.4950ish. Similarly, in October of 2008 the Euro rallied from about $1.23 to just over $1.51. To summarize, each rally covered roughly 30 cents! The current euro rally has covered a mere 10 cent range. Should we see a 30 cent rebound, the euro would make its way toward $1.34. Not coincidently, a value 30 cents from the March low represents the down-trend line that dates back to 2007.
In a nutshell, it hasn’t paid off to focus on fundamentals while ignoring the chart and the implications of an over-crowded trade. The Euro-zone fundamentals might seem dismal, but we’ve been here before and the outcome didn’t resemble the expectations of the majority.
