For most of this year, currencies like the euro and British pound have seen some surprising strength against the US dollar. The GBP/USD has rallied almost straight upward for more than 1000 pips and the EUR/USD made it all the way to approach the key psychological mark at the 1.40 handle. But the real question forex traders should be asking is whether or not these moves actually match the underlying market fundamentals. If this is not the case, we could be in for some major market corrections during the second half of the year and it will be important to position for these moves before they actually occur.
Of course, it is always essential to watch the broader activity in the US dollar. One of the best ways to quickly assess the relative strength of the greenback is to look at some of the ETFs that track the value of the dollar. One of the better examples is the PowerShares DB US Dollar Index Bullish ETF (NYSEARCA:UUP), and watching the price activity will give you a good sense of how the dollar is traded against most of its major counterparts. This can remove some of the confusion that is typically associated with trying to monitor the performance of several forex pairs at the same time.
Potential Monetary Policy Changes
But when we look specifically at the Eurozone (and the Euro itself), there are some troubling factors that could start to reverse the strength we have seen for most of this year. Specifically, we have started to see macro data that indicates underlying fundamental weakness in the shared economy. "The latest examples of Euro weakness can be seen in the German-Services PMI, which came in at 54.0 for the month of March," said Rick Bartlett, markets analyst at CornerTrader. This disappointed initial estimates, as the flash results were much better at 55.5."
Additional examples can be seen in this month's Eurozone Manufacturing numbers, and the relatively subdued Composite and Services PMIs. At this stage, there is little evidence of strength in the Euro economy as a whole and this could easily lead to renewed speculation that the European Central Bank (ECB) will be forced to alter its monetary policy stance in order to meet the requirements of a sluggish economic performance. What this really means is the introduction of new stimulus policies and if we start to see voting members of the ECB suggest this as a real possibility, we can expect the Euro to start taking a major tumble from its recent highs.
Similar to UUP in the US dollar, ETFs will be a good way of monitoring activity in these areas. Any suggestion that we are likely to encounter new stimulus measures in the Eurozone should weigh heavily on the CurrencyShares Euro Trust ETF (NYSEARCA:FXE). By proxy this could also extend to the Guggenheim CurrencyShares British (NYSEARCA:FXB). So for those currently bullish on these assets, it is best to proceed with caution.
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.