Euro breakout

A fine example came in the last week of October. The market expected the Fed to make a hawkish statement after the Federal Open Market Committee (FOMC) meeting on Oct. 25, emphasizing that fighting inflation is the Fed’s first job.

Based on numerous comments by Fed officials ahead of the meeting, many analysts had gone so far as to forecast additional rate hikes instead of a new cycle of rate cuts, which had been the conventional wisdom only a few weeks before. The yield on the 10-year T-note rose from 4.53 percent on Sept. 25 to 4.86 percent on Oct. 23.

But the Fed disappointed the market. The statement was not hawkish, and it even removed language about oil and other commodity price pressures. The yield on the 10- year note fell to 4.72 percent the next day. The dollar doesn’t necessarily follow the 10- year note in lockstep, but the fixed-income market often sets the tone for the foreign exchange market.

If the Fed is less worried about inflation, a key reason is that it expects overall growth to slow down and thus remove inflationary pressure. This is what Fed chief Ben Bernanke said after the September meeting, and so third quarter GDP, due out on Friday, Oct. 27 (two days after the Fed meeting), became the most powerful number in the trading universe.

The consensus forecast was for 2 percent in Q3 after 2.6 percent in Q2 (4.1 percent overall for the first half). We generally assume the consensus forecast is priced into the dollar, so if the number had been exactly 2 percent, perhaps nothing much would have happened. The range was 1.2 percent to 3.2 percent. A number well above 2 percent would mean the rate-hike scenario was still a real possibility, while a number notably below 2 percent would support the rate-cut scenario. GDP became the tipping point.

GDP came in well under 2 percent (only 1.6 percent), so all ideas of inflation-fighting rate hikes went out the window. The bond yield fell to 4.68 percent after the release, and the dollar crashed.

A different bit of information hinted the dollar was being set up for a crash: Volatility was abnormally low, and low volatility precedes a breakout. Right after the Fed decision, one-year euro/U.S. dollar (EUR/USD) volatility was at a 10-year low of 6.95. Before the GDP release, the key option barrier in EUR/USD was 1.2700, so a breakout above that level would constitute a turning point. Within 15 minutes of the GDP release, EUR/USD broke over 1.2700 and hit 1.2747. Traders smelled blood.

A word of warning about low volatility: While breakouts are almost always preceded by low volatility, not all instances of low volatility are followed by breakouts.

Sometimes the market is simply uncertain about what is going to happen or how to trade a particular set of conditions. Volatility can remain low for long periods with no breakout.

It shows the breakout above resistance and the bullish engulfing candlesticks that preceded the breakout. The first bullish engulfing candlestick was followed by a “bearish harami,” which cast doubt on the bullish candlestick. But two days later another bullish engulfing candlestick formed, offsetting the “indecisiveness” of the bearish harami. This second bullish engulfing candlestick occurred the day before the Fed announcement and indicated trader skepticism — they really needed to hear a hawkish statement and were ready to “punish” the dollar if they didn’t get it. Finally, the week ended with three white candles, another bullish signal. At this point price had also broken out above the down trendline.

It shows a 14-day relative strength index (RSI) rising up from the oversold level that preceded the breakout. Overbought or oversold conditions don’t always precede a move in the opposite direction, but this time it was an excellent clue. Finally, it shows the breakout in a different way — price rising over the top of the linear regression channel. This channel measures the standard error on either side of the center linear regression, so a break of the channel means the move is statistically abnormal — an opportunity in chart-reading.

If you didn’t act during the day as these indicators were developing, by the end of the day you were convinced. You could have bought the euro/dollar rate without ever seeing a chart, though. The day after the bad GDP report and breakout move, the euro opened at 1.2747. It hit a high 10 days later at 1.2926. If you had captured that move, your gain would have been 179 points — which is more than you will ever make in a single day unless you are trading a far bigger position size (the average daily range in the euro is about 140 points). And where would you get the courage to trade 10 contracts if you didn’t know the stories behind a price move?