EUR/USD Weekly Outlook 8/10 thru 8/15 2008

To my knowledge, never since the introduction of the euro currency in 1999 has there ever been a larger, more pronounced one week sell-off like we had last week. The entire week last week we emphatically discouraged traders from buying the euro and to stay short.

The big question on every trader’s mind is – where do we go from here? Well, if I could give you a definitive, take-it-to-the-bank answer I wouldn’t be writing this update, I’d be busy calling friends, family, and associates to get my hands on every penny I could to place an “all in” trade.

So I can do the next best thing which is distill the whole situation down and lay out the probabilities using the three factors that are responsible for moving the EUR/USD on a daily basis:

1. Fundamentals/Central Bank Monetary Policy
2. Commodities/Equities/Securities
3. Geo-political Events

Fundamentals:

Looking at what’s on the books for this week, fundamentally, the euro remains at risk. That being sad, the dollar is also under fundamental risk this week. Last week’s fundamental data clearly favored the dollar because that particular set of data was bolstered by the $100+ billion worth of free money the government handed out in the spring.

Three fundamental areas dominate the market this week: Retail Sales, Inflation, and Growth.

Based on data from Wal-Mart, consumers blew out their stimulus checks on discretionary items like flat panel TV’s, the latest video games for Xbox, junk food, beer and wine, and have since pulled back now that the free money is hanging from their walls and the empty beer cans are sitting in the trash can. I’m not too terribly optimistic on the USD retail data because in July gas prices were at their worst with the national average being about $4.06 per gallon.

Plus, what I saw during my own “field research” in July were empty stores, empty restaurants, empty roads, and empty social gathering establishments. The only thing that concerns me with a USD- forecast on retail data is the fact that the underlying fundamentals of the market have already begun their shift and based on past fundamental data patterns, the trend of USD+ upside surprises can go on indefinitely while Europe’s fundamental landscape continues to erode.

Turning to consumer-side inflation, we get CPI data out of both the U.S. and Europe. Once again, the euro takes on more risk than the dollar. One of the main catalysts for last week’s historic euro sell-off was Trichet’s dovish rhetoric on growth coupled with no strong vigilance against inflation. In addition, Trichet already told the markets that the ECB’s last rate hike would suffice to solve Europe’s inflation issue.

In fact, Trichet told the markets twice that the last rate hike would bring inflation down to desired levels, so this leads me to believe that we’re definitely not getting any upside surprises on Europe’s CPI data. In my view, anything less than an upside surprise on CPI is going to do more damage to the euro.

The U.S. CPI data prints 3.5 hours after Europe’s. If the European data prints below 4.0% and the U.S. CPI data prints at or above expectations, this could easily put the market back in the mood for another massive sell-off of the euro. And it’s that scenario that I’m expecting and will be prepared for.

The other fundamental factor that puts the euro under tremendous pressure is their GDP data which also prints on Thursday. I am very bearish on Europe’s growth, you know this if you’ve been reading any of my commentaries since January. For months we’ve been forecasting that the growth sector would be the first to crumble in Europe and we’re now seeing this reality play out right before our eyes.

In addition we get industrial production data for Europe and the U.S., plus Trade Balance, TIC Flows, and the Michigan Sentiment – all USD data. I’ll cover those pieces of data throughout the week, but be aware those can be market movers.

This week could really just boil down to a battle of worsts… most of the data we’ll see this week for the USD and the EUR shouldn’t be too pretty or too promising. So I think it could just come down to whoever’s data isn’t as nasty is the one that doesn’t take a beating.

Market Correlated Variables:

With the dollar’s massive gains the past two weeks the natural reaction in the commodities market is to sell-off, which in turn only pushes the dollar further up. The dollar really started gaining momentum when gold and crude topped out and began their sharp descent.

Right now gold is sitting in the mid $850’s and crude is around $115. Don’t forget just a few short weeks ago crude was at $147 and gold was in the $950’s. If commodity bulls step up to the plate and add their bullish liquidity into the crude pits and the gold market, the euro slide will likely come to an end.

In my view the euro will not be able to gain any traction until gold and crude stop selling off. It’s really that simple. And this is where some of the geo-political events can come into play, namely the battle between Russia and Georgia.

But before we cover the geo-political aspect, the other thing I’ll be watching is bond yields and the Dow of course. The bulls on Wall St. are flying high despite tremendous instability with the big U.S. financial institutions, the meltdown of Fannie Mae and Freddie Mac, and the likelihood of more U.S. bank failures in the weeks to come.

I believe some of the big players like Merrill Lynch and Citi are going to come crawling to Asian and Middle Eastern financiers to add liquidity. I don’t believe all of those big firm’s assets have been properly marked to market which means the dollar remains at risk if and when the big players show more signs of weakness and even bigger losses on their books.

Geo-political:

Last week tensions between Russia and their former Soviet-era stronghold Georgia went at it. The fighting is in a region called South Ossetia, which is an autonomous region that is occupied with Russians and with people who want to be Russian citizens.

Georgia is a strong U.S. ally, much stronger than Russia claims to be. Obviously there’s a cultural issue at play here, but there’s also another factor which I think is driving tensions, and this is: crude. That area in South Ossetia is oil rich and is also an area for oil transport.

Again, this is just my opinion, but I believe oil is a strong underlying factor in this conflict. I also believe the strong euro sell-off on Friday was likely fueled by this conflict to some degree. It’s been some time since the markets have seen a geo-political event like this, so naturally there will be a pronounced reaction and there could be more to come this week if the fighting escalates and peacekeepers fail at their mission of ending the violence.

What we will need to watch is whether or not crude gains in response to this fighting and whether or not the so-called “flight to safety” back into the USD continues. This geo-political event has me concerned because I don’t quite understand why Russia is taking such aggressive actions against Georgia when it’s clear they have the power to crush them without even really blinking an eye.

If it’s just about oil I suppose those intentions will be made clear soon enough but if there’s more to the story, like Russia showing the world it’s military might, this could lead to some real wackiness in global markets and our market of course.

I will be watching to see how the U.S. decides to play “big brother” and what Europe has to say, NATO, and the U.N. I lived in Russia and only have a rudimentary understanding of Russian politics and military mindset but I do not see the Russians succumbing to political pressures from the U.S. and Europe.

EUR/USD:

As I’m writing this market’s not even open yet and right now the euro is trading at a pre-market price of 1.5045. My bias, just as it’s been for the past three months is still strongly bearish on the euro. I do not see any firm establishment of a bottom at this point.

The 1.5000 level held up under intense pressure and low liquidity on Friday. I need to see the price action and the euro price patterns in order to feel confident we’ve established a stronger base of support. Until then, I’m not buying the euro and I will stay short and keep shorting every rise.

Last week the euro lost over 3.5% to the dollar and a total of over 5.0% in the past three weeks of trading. This is a dramatic and unprecedented depreciation for the euro. Shifting monetary policy at the ECB and the decline in commodities are the main catalysts for these moves.

Fundamentally, the U.S. has not turned the corner. In my opinion the housing market has not bottomed, the jobs market remains under intense downside pressure, the consumer remains in pullback mode, and there could be more financial woes on the horizon.

Those are my basic arguments for why the euro should not loose too much more ground to the dollar. The other factor is where the USD Index is at. It’s sitting right around some strong resistance. So, I will also need to see if how that resistance level on the Index holds up this week.

It’s really pretty simple… if the USD Index hits a brick wall up here at these levels, commodities can rally, and the euro fundamentals don’t print with serious downside surprises, I see no reason the euro can’t find a bottom and attempt a move back up after getting hammered so hard and so dramatically the past three weeks.

We know from EUR/USD price action patterns that the euro will always move faster and further to the downside than it will to the upside. I believe after moving down about 600 points last week that the pair is due for some upside retracement.

It wouldn’t surprise me to see a few more tests to sustain a break of the 1.5000 level, but down here I’m just not comfortable adding any more shorts. Also, I will wait for price action to confirm the euro has established some solid support and once I get my confirmations, I will likely begin buying again and taking profits on some shorts that are well into profit.

Many of you will recall me saying that my forecast was for the euro to give 1,000 points to the dollar from the all-time high. Well, our all-time high is 1.6038 and we’ve given back those 1,000 points.

Risk Management:

The last point I want to cover is risk management. Poor risk management sent MC buzzers ringing around the world like church bells on Sunday morning. Painfully expensive lessons were handed out last week. I wish it didn’t have to be that way, but that’s the nature of the market we trade.

I just hope that my constant mantra of “not overleveraging” will be justified after traders sit back and reflect on what a beast the Forex market can be. I cannot stress enough the need for proper and strict risk management this week.

We could easily see some volatile price swings and more exaggerated moves as liquidity remains low and many factors are at play within the markets. Be prepared for the unexpected please.

That's it for now. Be smart...