Using the Euro to Determine Stock Market Direction

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By Jim Hyerczyk
Commodity Trading Advisor

The recent surges in the U.S. Dollar and U.S. Stock Indices may be signs that the “risk on, risk off” scenario that investors have become accustomed to may have come to an end. Over the course of the stock market’s three year rally, the relationship between the Dollar and stocks has most often been an inverse one. In other words, investors had used the “Euro Barometer” to set the tone of their trading day. This relationship between the Euro and the stock market had even caused some stock trading veterans to remark that they don’t even look at the fundamentals anymore to decide the direction of the stock market; they just look at the Euro.

The easiest explanation for this type of trade decision making was that investors had two decisions to make, buy U.S. Treasuries or the Greenback when they wanted safety (risk off) or to buy higher yielding assets such as the Euro or equity indices when conditions dictated a “risk on” day. Sentiment appears to have shifted and this “risk on, risk off” decision making process may have come to an end because of the improving U.S. economy and the faltering European economy.

A strengthening U.S. economy and talk of possible interest rate tightening sooner than expected by the U.S. Federal Reserve is helping to pressure the EUR USD this week.

At the end of last week, the U.S. government reported a better-than-expected Non-Farm Payrolls report. This led some traders to assume that the Fed would take a “wait-and-see” approach before applying another round of quantitative. Additionally, some speculators were betting that the Fed would change the language of its monetary policy statement to reflect an improving economic outlook.

Although the European Central Bank is holding its benchmark interest rate at 1.00 percent, the uncertainty over sovereign debt and the possibility that the Fed would refrain from implementing additional financial aid programs caused some traders to pare their long EUR USD positions. This action has been pressuring the Euro all week while supporting the greenback.

On Tuesday, the Federal Open Market Committee met to discuss monetary policy. After the meeting it was revealed that the Fed acknowledged signs of a strengthening economy. This brighter U.S. economic outlook is helping the dollar as it is encouraging investors to downplay expectations of future stimulus measures. 

As usual the Fed did not come out and answer clearly the questions about the prospects for further monetary easing, but it did offer a slightly better outlook for the economy. A healthy combination of solid retail sales and rapidly improving U.S. job growth helped lead the central bank to make this assessment. This also means the prospects for another round of QE has been harnessed at least in the short-run.

While another round of quantitative easing would have been the equivalent of printing more money and bad for the dollar, the uncertainty in Europe continues to weigh on the Euro. In addition, the Fed eased up on its dovish tone by mentioning growth and inflation while other major central banks remain a bit more dovish.

There is no question that the economy is improving although at a snail’s pace. However, the Fed is still concerned about the high level of unemployment and the bad U.S. housing market. Because of this, it left the door open for further stimulus, most likely in the form of additional bond buying later in the year.

The diverging economies between Europe and the U.S. are likely to be the catalyst that drives the EUR USD lower the rest of the week. Demand for higher risk may slow down the rate of decline, but the trend is down for this currency pair and the bias remains negative. Helping to support this assessment is the positive growth of the U.S. economy contrasted with the contraction in several key areas in Europe.

So while the ECB continues to leave interest rates at 1.00 percent while providing cheap loans and stimulus, at least temporarily, the Fed will refrain from such activity, giving the Dollar a boost.

Technically, the weekly trend is down for the EUR USD; however the currency pair is headed toward an uptrending Gann angle at 1.2983 this week along with a key 61.8 percent retracement level at 1.2952.  If this angle and retracement level holds as support then the market may trade into the support cluster at 1.3063 to 1.3054 the week-ending March 30.

With the U.S. economy improving and Europe still mired in financial turmoil, investors are searching for more certain economic outlooks, and the U.S. economy combined with Fed activity seems to be offering what they desire. This should mean more robust trading activity in both the Dollar and the stock indices. In the meantime, despite the apparent short-term settling of the Greek sovereign debt crisis, investors are still likely to shun Europe because of the boatload of debt issues still facing other countries in the Euro Zone. This means more capital is likely to flow where there is more certainty and that is into the Dollar and U.S. equity markets.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.




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