Could events in Italy put downward pressure on the EURUSD?

The EURUSD is the most traded foreign exchange pair in the world. The common currency, as the euro is also known, is the official money in 19 of the 28 European Union member states. At the same time, it is also official money in smaller states like Monaco or Vatican City which are not EU members. Additionally, some countries, whilst having their own money, have currencies pegged to the euro i.e. Denmark, Bulgaria or some African nations like Morocco, Ivory Coast, Congo. However, the euro has only been in existence for roughly 20 years. Yes, there was agreement in 1995 about the setup, but officially it became an account currency in 1999. It started life on a back foot, quickly moving below $1 as for example someone would only need $0.85 to buy one euro in early 2000s.

In July 2008 the exchange rate was more than $1.60 for one euro, so it almost doubled in less than 10 years. The reason behind that impressive rally? By and large, it was perceived as a proxy for the Deutsche mark, Germany’s former currency. After reunification in 1990, Germany struggled economically for the best part of the next decade but then it made a comeback with a vengeance. Amid globalisation, Germany quickly became an industrial powerhouse, the engine driving the European manufacturing force. And of course, the euro strengthened with it.

Since 2008 though, the euro has been mostly on a downward slope against the US dollar and is now trading just below 1.12. First, we had the recession in the US which spread like wildfire and brought demand for the dollar as a safe haven currency (out of euros). That was followed by a shift from globalisation and free trade mindset to a more protectionist attitude among some of the developed world’s top politicians (if not in reality at least in rhetoric).

The euro got caught in the middle. On one hand, Germany is a country running a budget surplus and 40% of its economic growth is due to exports. On the other hand, struggling economies like Greece, Italy or Spain are running deficits. Their domestic troubles pushed the euro down which, from a monetary point of view, benefited exporting economies (the Netherlands, Germany). We know that a weaker currency is good for exports, but it also makes imports more expensive.

It easy now to see why some Eurosceptics are regarding the euro as ‘the worst of both worlds’. It is too strong for countries like Germany and the Netherlands, growing on steroids due to that ‘monetary unfair advantage’, whilst other countries like Spain, Italy or Greece feel the opposite effect due to the same process. That sparked a string of anti-euro politicians coming to power in Europe or threatening to do so. Recently, Italy’s leader Matteo Salvini triggered a government crisis in trying to push for fresh elections. His anti-Brussels views are well known.

Currently we are in the middle of a currency war where everyone wants to devalue its own money in order to get that bit of extra edge on its trade partners. Lowering the central bank interest rate is among the first measures taken so far in trying to achieve that. Going forward, the direction of EURUSD will probably be conditioned on those devaluation attempts, who’s going to do it more effectively?

The overall trend of EURUSD is down

As we mentioned earlier, it rallied to a high of 1.6038 seen on July 2008 but since then we saw a string of lower highs and lower lows. There are also a few counter-trend rallies which lasted for 12 to 18 months but the broader direction is clear – South.

Bearish outlook

The market price is below the 9- and 21-week moving averages. The 9-week MA (red line) has crossed below the 21-week MA (Blue line) in December 2017 and if history is any indication, that cross was a bearish signal. In the past (red circles) that happened in November 2008, March 2010, July 2011 and September 2014 and there were all reliable downtrend predictors. Next long-term support is around 1.0850 followed by record low of 1.034 seen on January 2017.

Bullish outlook

On the upside, we see resistance around 1.1550 which held well in the past (for 2 and a half year from February 2015 to July 2017) as well as resistance at 1.2050 and 1.2370. A cross above 1.237 would shift the medium-term trend to bullish.

The blue circles on our chart show the inflexion points when the counter trend rallies happened and could have been taken advantage of as they lasted more than 12 months.

A rally back to 1.167 which is 23.6% Fibonacci retracement from a high of 1.6038 to a low of 1.0340 should also be considered as a short-term possible scenario.

The anatomy of a rate cut

Yesterday, the US Federal Reserve cut its benchmark interest rate by a quarter of percentage point to a range of 2%-2.25% which was the first cut since 2008. Usually, stock markets enjoy when the Fed slashes rates as easing means cheaper funds which at least partially will go back into stocks, propping up prices.

However, the outcome was a drop in US share prices coupled with a higher US dollar. One could easily think neither result was intended. That seems to be opposite to a logical intention because its rather hard to believe the Fed wanted a lower stock market and/or a stronger dollar at the present time. A stronger dollar makes it harder to pay down debt as well as hurting exporters in the current trade disputes. And a slumping stock market going into election is bad for politics. President Donald Trump has been tweeting continuously, bragging about the all-time highs in shares and at the same time ‘advising’ the Fed to take measures to weaken the US dollar.

So let’s see what happened in detail.

By and large the markets had been widely expecting a very dovish Fed which means a 25basis point cut accompanied by hints the second and eventually third cut will follow by the end of the year. But faced with a rather stronger than anticipated economic data lately, the Fed struggled to justify the decision going into the meeting. It blamed the US trade policy, slowing global growth and a lingering below target inflation. Many called it ‘an insurance cut’ reminiscent of ‘Greenspan put’ (a cut in interest rates done by the former Fed Chairman at the first sign the US economy went into troubles).

Nonetheless, during the press conference that follow the decision Fed Chair Jerome Powell described the cut as a ‘mid-cycle adjustment’ adding that ‘it was not the beginning of a long series of rate cuts’. The markets were shocked and interpreted the comments being rather on the hawkish side. After all they were widely expecting a dovish statement, betting on interest rates being pretty much a full percentage point lower in the next 12 months.

In reaction, the US dollar strengthened hitting a more than two year high and the Dow Jones fell 478 points initially. It closed the day 330 points down in its worst session since May.

Now we know that the midcycle adjustments down in 1995 and in 1998 were 75 basis points each (three cuts each). On the other hand, usually when the Fed starts cutting is not a one off move. Is Powell trying to say yes I’m going to make it easier for you markets but not that easy? So poor communication or not we might expect the next Fed decisions to be more data dependent.

The main trend Dow Jones according to the chart is down. The trend turned south mid July as we can see a string of lower highs and lower lows in a move that was exacerbated with yesterday’s big drop to 26,718. The price action needs to see a rise above high of 27,402.5 seen on July 15 for the long term trend to turn bullish again.

Bearish outlook

The next immediate support is around 26,720 which held its ground during the last test. A sustain move below that level will signal the growing presence of sellers and opened the door for a test of 26,640 where bulls and bears were at loggerheads in late June. If that level fails then look for selling pressure to test 26440.

Bullish outlook

A slight rebound is currently underway but it’s hardly bargain hunting feeling more like a dead cat bounce at the moment. We need to see at least a rise above 27,000, next resistance ( and 9 day moving average ) to indicate the presence of returning buyers. If the rally back then creates enough upside momentum investors could see the rebound extend to 27,078 and possible 27,157.

To be noted that yesterday violent nosedive took the price below both 9 and 21 days moving averages and in another bearish sign 9 day moving averages crossed below the 21 days moving averages.