Should You Prepare To Short EUR/USD?

Summary

• EUR/USD is approaching an upper bound of 2.5-year trading range.
• There is a bearish divergence between EUR/USD and 2-year yield spreads.
• Eurozone bank stress is still an issue.

Technical Picture

First and foremost, I should say that the trend in EUR/USD is still bullish. On a purely technical basis, long positions are preferable as long as the exchange rate remains above the 1.1140-1.1120 area. If euro can break above 1.1500, then one can expect the upside to extend towards 1.1590, 1.1615, 1.1720, 1.1820 and 1.1860. However, I believe that a more likely scenario would be either a false break above 1.1500 followed by a correction or consolidation followed by a moderate retracement. Targets are 1.1300-1.1290, 1.1215-1.1200 and 1.1120 and 1.0900 in extension.

Source: Trading View, personal analysis

Resistance at 1.1500 is a very strong one. It is the upper bound of a 2.5-year trading range. Euro has repeatedly failed to break above it (see the chart above – notice failed attempts in August 2015, in October 2015, then in April and May 2016). Furthermore, a bearish divergence in the relative strength index (RSI) seems to be forming on a daily chart and RSI is actually very close to breaking below its own upward sloping trend line from June 20, 2017.

Fundamental Picture

There is so much information on fundamental analysis in EUR/USD that it is becoming extremely difficult to discern important trends from trivial developments. Noise is all over and one needs to stay focused and concentrate on critical issues that actually make sense. I decided to show you just three charts that in my opinion best illustrate the evolving bearish divergence in EUR/USD.

Divergent Monetary Policy

Source: ECB, FED, investing.com, personal calculations

In remarks delivered to the U.S. House Financial Services Committee, Janet Yellen reiterated that the gradual rate hike outlook stays in place. At the same time, Mario Draghi, the head of the European Central Bank, has recently played down speculation that ECB intends to drop its experiment with negative interest rates later this year. In short, the Fed remains relatively hawkish, while the ECB is still committed to keeping rates on hold at least until the end of QE.

Obviously, divergent monetary policy between the Fed and the ECB has narrowed bond yield spreads and actually made them negative (see the chart above; the spread is between Germany and U.S. 2-year government bond yields).

As of today, the spread remains negative and is close to an all-time low, yet EUR/USD has rallied and has touched a multi-year high (see the chart below). This situation represents a potential bearish divergence.

Source: CMC Markets, investing.com, personal calculations

Euro-Area Bank Stress

You may recall back in 2014, everyone was talking about “PIGS”, standing for Portugal, Italy, Greece and Spain. These countries are among the most indebted in the euro-area. Their banks are among the most distressed and ECB has repeatedly found significant capital shortfalls – especially in Greece. The situation remains tense. One way to measure euro-area bank stress is to look at the spread between the PSI Financial Gross Return Index and the Prime Xetra Financial Services Index (see the chart below).

Source: Bloomberg, FXCM, personal calculations

The spread essentially measures the health of Portugal financials (banks and other lending institutions) relative to the health of German financials. As you can see, the spread is still very low, indicating that lenders in Germany are in a much better state than their Portuguese counterparts. Also, notice the spread’s correlation with EUR/USD – there is now a clear bearish divergence. Incidentally, similar divergence was present back in mid-2016 and eventually led to euro depreciation.

Conclusion

I will be looking for an opportunity to sell euro as it approaches the 1.1500 level. EUR/USD pair is an obvious choice, but one could also sell euro against other currencies – particularly, the Australian dollar (see this article outlining the bullish case for AUD/USD). Targets are 1.1300-1.1290, 1.1215-1.1200 and 1.1120 and 1.0900 in extension.

Analyst’s Disclosure: I/we 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.