Anatomy of a retracement

The euro has been trending upward powerfully since the first week of September 2004, when the current account problem pushed itself to the forefront of the news (see “The Great Global Imbalance Hoax,” Currency Trader, December 2004). The trend picked up steam in October and November, punctuated by a couple of minor retracements (defined here as a series of lower lows and lower closes that persists for longer than three periods in an uptrend).

In the first week of December, the euro retraced quite a lot. In fact, daily lows twice penetrated the lower boundary of the linear regression trend channel. Nobody actually thought a trend reversal could be in the works, but when prices fall by a large amount like this, traders who went long near the highs are suffering and don’t want to see their losses get bigger. A wave of stop-loss selling takes place, complicated in this instance by pre-holiday and year-end profit-taking by position traders who had gotten in much earlier.

Most analysts believe the euro will break the upside resistance line (red), as it has done twice before.

Meanwhile, the euro is in the grip of the technicals, which dictate the retracement should take a particular form — the Elliott Wave sequence. Traders twisted the meaning of fresh data during the retracement week to match that expectation. Specifically, the current account deficit was not as bad as expected, so the euro fell. In any objective analysis, this is a perverse move based on a faulty interpretation.

In fact, it depends on looking at the data in seasonally adjusted terms; in unadjusted terms, the current deficit was worse. The deficit is still 6.1 percent of GDP, the critical number that underlies the dollar downtrend in the first place, and the most recent data indicates a third consecutive quarter of worsening deficits.

Economists scratch their heads at this willful misreading of the news, but technical traders just try to figure out where the retracement will end so they can re-enter. There are two possibilities on the chart. We can wait for the price to break upside resistance, or we can watch the indicator in the upper window, a momentum oscillator, to signal the euro is oversold. Once the indicator pops up from the oversold line, the trader has a bigger profit potential than if he or she was waiting for resistance to break.

Traders will line up the true weight of the news with the corresponding price change. If news continues to be badly dollar-negative in any objective evaluation but the euro fails to rise, the price is still in the grip of the technical traders who think their retracement hasn’t ended. If the news is only mildly dollar negative but the euro rises anyway, it may be time to consider a new position even if neither of the two technical indicators on the chart give the signal –– some other technical indicator can always be found to justify the position the news suggests.