Introducing a technical constraint

If equilibrium is what we are about to see in the FX market, we have to ask what shape it will take on the chart. Last summer traders witnessed a prolonged sideways trading range. That could happen again for a large part of this year, too. The FX market is not always in trending mode.

But before that happens, we need a resolution of the thinking on the current price action. The general feeling is the euro rose over three years, and is now correcting downward on less-negative feelings about the dollar and the U.S. place in the global economy.

It shows the big-picture euro/dollar (EUR/USD) rise from the October 2000 low of 82.50. The normal high-low range over several months tends to be .20. We would have to see a downside breakout below 1.2590 (the bottom of the range projected by the regression channel — dotted lines) at midyear to be convinced the euro uptrend is over; it’s just as easy to envision a move to 1.4560 (the top of the channel extension). The middle line is the linear regression, which extends to 1.3570 at the end of June 2005. So what would a sideways movement look like and where would it start? If we are unlucky, it could look like the horizontal lines , which would be a replay of 2001.

In the FX market, a high percentage of analysts like the Elliott Wave theory of price development, and many also like the Fibonacci number sequence as a guide to counting the depth of corrective waves. Everyone can see that price moves look like waves, but I’ve never had much luck counting waves.

Somewhat more impressive is the Fibonacci retracement concept, which implies after a big impulse wave in one direction, the price will retrace part of its move in the other direction. The retracement will be 23.6 percent, 38.2 percent, 50 percent, or 61.8 percent of the original move. The problem is deciding when the original move starts. Applying standard Fibonacci retracement lines forecasts a 50 percent retracement of the trend to 109.50 or so. This move would not be a new trend, just a retracement. If you are an economist or a very long-term investor (Warren Buffett, perhaps) you might be willing to consider a move from 1.36 to 1.10 as only a “retracement.” But if you are a mere mortal or an actual trader, it would certainly feel like something else.

This applies the retracement concept to the trend starting at the late-August 2004 low. This chart is a different kettle of fish. On this version, a 50-percent retracement produces a downside target of 1.2638, whereupon (if the euro uptrend is still in place) we expect the temporary, “corrective” dollar rally to end.

There are a dozen other ways to show retracement levels. If and when we do get a return to the euro up move, you can bet that you will see analysts claiming to have picked the right retracement level all along.

This kind of chart work is why you see euro forecasts of 1.05 rubbing elbows with forecasts of 1.45. Both can be found on the charts using widely used charting methods. We tend to think the Golden Goose rule is a powerful concept and that it will throw dust in the face of all the retracement crowds.

If the Golden Goose rule is right, and the market is coming to tolerate the global imbalance, we will get the sideways range-trading market. Trading the currency market is about to get very difficult.