EUR/USD: A Perfect Short, Whilst Ignoring The Murky Fundamentals

 |  Includes: FXE, UDN, UUP
by: James Brodie

FX traders have a lot to be frustrated about. First of all, they are witnessing ever decreasing volatility highlighted by the CBOE Eurocurrency volatility Index ("Euro VIX") now at 5 year lows. In fact the volatility of many G10 pairs and crosses is at multi year lows, and AUD/USD is unchanged from 21 months ago, trading in a consistently narrowing range.

Secondly they have to trade between flip-flopping headlines as politicians kick cans down roads in Europe, and fiscal cliff talks see-saw from constructive reports to pessimistic outlooks in the U.S.

What cannot be ignore though is the price action, and selling the EUR/USD at current levels offers a risk:reward payoff of nearly 6:1.

The first chart shows the EUR/USD currency plotted against the differential of the two respective 2 year IRS rates (interest rate swaps). Here we can see that the correlation of the currency and the interest rate markets has broken down, the euro has moved higher without a simultaneous move higher in euro swap rates. This is a clear example of a "clean out" of market positioning. The market has been trading short EUR/USD in the medium term and over the last 3 months weak shorts have been forced out of the market. Short end rates will not be moving in the near term, so it is a matter of time before the currency trends back towards the 1.20 target level stubbornly indicated by the swaps market.

EURUSD vs 2 year Interest rate differential (source : Bloomberg)Click to enlarge
(Click to enlarge)

The currency is also now pushing up against a strong downtrend from May 2011. This is where the real risk-reward opportunity comes into play.

EURUSD 18 month trend channel (source: Bloomberg)Click to enlarge
(Click to enlarge)

If fundamentally you believe the currency should be trading lower, and/or you believe the interest rate differentials will gravitate the currency towards 1.20 then a short position initiated at current levels with a stop loss above 1.3172 is a compelling trade.

The reason I leave the stop above September 2012 highs 1.3172 is because we are not yet at extreme standard deviations from the mean. In the very near term we may see a temporary "false break" above 1.3000 and through the trend line, but at that point further resistance from the Bollinger Bands will add new selling and downward pressure before the September highs are met. Using the default 2.0 standard deviation Bollinger Bands, statistically the price will only stay above the upper band 2.5% of the time, so the closer the currency gets to the upper band at 1.3070 the increased resistance (selling) it will meet.

EURUSD Bollinger Band (source:Bloomberg)Click to enlarge
(Click to enlarge)

Of course no trades are ever certain, and one of the few certainties in the financial markets is that we can never predict the politicians. So while the fundamental background is so unclear we do have the opportunity to spot a strong risk reward trade by using a combination of FX/Interest rate arbitrage, technical analysis and mathematical statistics to short the EUR/USD at 1.3000 with a stop loss at 1.3180 and a price target at 1.2050.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.