Is the Euro Rally Over?

I am always skeptical when I read articles in the Wall Street Journal touting what hedge funds are "going to do." Thursday morning there was a piece outlining how the hedge funds are getting ready to jump back in on the short euro trade if they haven't done so already. Are these articles penned to entice the 'little guy' to jump into the meat grinder? Or are some of these hedge funds trying to create a self-fulfilling prophecy? In light of their possible motives I thought it would be prudent to have a look and see what the supply/demand picture says.

The chart below is of the daily continuous euro futures contract. In the middle pane is a simple indicator that shows how many standard deviations the closing price is away from its 40-day moving average. I will explain this indicator later. The bottom pane is a plot of volume overlaid with the MACD (or momentum) of volume which is a great way to show how strong buying or selling conviction actually is.

First, take a look at the blue dashed line through the middle of the price plot at the 1.32 - 1.33 level. That is the level of a prior low. Technical analysis 101 states that what was once support is now resistance. What many new traders don't realize is that these areas also act as magnets for price in that they have to be 'corrected' or touched (in this case from the bottom) before the previous trend (in this case down) is ready to continue. The 'touch' happened on August 6 when the euro peaked at 1.3330 then reversed lower.

Next take a look at the middle pane. That is a simple indicator that shows how many standard deviations the closing price is away from its 40-day moving average. We will call this the 'SD Indicator'. The important thing to note there is that when the indicator reaches +2 or higher or -2 or lower, at least a short term change in direction is due. This indicator is not perfect by any means, but it can give a trader a good indication of when to take profits or when to enter an existing longer term trend. This indicator takes emotion out of analysis and gives a pure statistical look at where prices are in relation to their mean. The chart is marked to show instances when the indicator reaches +2 or -2. Notice that the indicator peaked over +2 in mid July and has been showing a negative divergence ever since as price pushed higher. That is saying that the buying pressure that pushed the euro off of its June low (short covering?) is no longer present.

Finally, take a look at the MACD overlay of volume in the bottom pane. Notice how the momentum is relatively flat as price has pushed higher. Typically new trends need a larger initial volume push to change direction as control changes from sellers to buyers. In this case, visual confirmation of a control change in this market is lacking. (Click to enlarge)

The euro is now approaching a dual support area in the form of its 40 day moving average and the small up trend line it formed off of its June low. If that trend line gives way, it is "game on" again to the downside. If not, the euro may have higher to go. Given the evidence presented here, I would suggest getting ready for a break of support and the accompanying broader market implications.

Disclosure: No positions