Rethinking assumptions

This scenario might seem reasonable, but it’s not. It assumes the Lehman Collapse Shock did not have a permanent effect on the primary trend. Once a trend is broken, we need to consider all factors anew. Notice the red support line connecting lows was broken along with the linear regression channel line.

Okay, so let’s assume the Lehman Shock started something fresh but it’s just not evident yet. Support and resistance get broken all the time and it doesn’t necessarily mean a move is over, but we can feel comfortable making such an assertion only if price now surpasses the previous intermediate high (upper horizontal gold line) at 1.4867, a level that occurred right after the Lehman Shock. If the Euro fails to match and surpass that level, it might test the previous low (bottom horizontal gold line) at 1.1815 from November 2005. In other words, there may be a new probable range forming.

We can try to measure the new range by drawing a new trend channel. In this scenario, the recent EUR/USD high is a breakout, as yet untested, above the upper boundary of a new downtrend channel. Let’s say the Euro falls by 50 percent of the original down move, or to about 1.3650. That would put it back at the channel top and, as we know, a 50-percent move is an important benchmark. Together with the failure to test and surpass the old intermediate high, it might mean the down-sloping channel is the right one.

The problem with this channel is it’s a work in progress — and it’s too steep. So let’s invent a new more probable trendline channel at about a 45 degree angle, which is the slope of the up move from 2006 to the high in 2008. It’s fairly crazy to construct linear regression channels out of thin air, but let’s add another assumption: high volatility and choppiness characterize the first phase of a crisis, and as players become familiar with the new environment, increasingly stable prices will emerge. In fact, currencies sometimes have prolonged periods of sideways price action with little or no trend. This makes a trendline’s slope less steep.

If this scenario is true and useful, the EUR/USD pair could not only challenge the October 2008 low around 1.2329, but also make a run below 1.2000 by this time next year— perhaps as far as 1.1000. In fact, 1.1214 is a 62-percent retracement of the bigpicture move from the low of 0.8229 in October 2000 to the high in July 2008 at 1.6038. Fibonacci numbers are an unfounded superstition, but enough traders like them that we ignore them at our peril.

If the imaginary trend channel is the correct scenario, why would the price development proceed that way? For once we have an easy answer. The European Central Bank (ECB) has been in denial, stating that inflation is still a worry and they need to see more data before they can cut rates further. Now that the Fed has effectively cut to zero, the Bank of Japan has cut to nearly zero, and the Bank of England is widely expected to follow suit in early January, the ECB is the only major central bank that is out of line. The yield differential favors the Euro right now, with the overnight repo rate at 2.5 percent.

Evidently the ECB is not impressed by French wholesale inflation falling from 4.3 percent year-over-year in October to 1.9 percent in November, or other indicators of severe contraction. The German Kiel Institute says German GDP will fall 2.7 percent in 2009, to be followed by a pathetic 0.3 percent in 2010. One ECB policy member said in December it would be logical for the bank to cut rates once it sees inflation expectations dropping under 2 percent.

But the ECB is not entirely asleep at the switch. On Dec. 19 the ECB acted to remove some of the carry-trade charm of the Euro and halt a flood of incoming deposits from the dollar and the British pound by cutting the official deposit rate by 50 basis points to 1 percent below the key repo rate of 2.5 percent, and raising the lending rate by 50 basis points to 1 percent above the key rate. This created a wider rate spread “corridor.” It still leaves the Euro with a rate advantage for deposits, but a much smaller one, and it has the side effect of raising the cost of borrowing for European firms. You’d think that’s the last thing a central bank would want to do in the current economic environment, although it has the bonus of raising bank profitability.