Euro Bulls Stymied by ECB Rhetoric May Find Strength in Charts

(Bloomberg) -- The euro may have taken a beating this week amid a warning by the European Central Bank about a potential overshoot, but trader positioning as well as signals from the options market and charts suggest the currency’s resilience is intact.

Those indicators suggest a march toward 1.2000 against the dollar, a level the euro hasn’t traded at in more than two years, can’t be ruled out.

Traders’ Conviction

The euro seems to have marked its short-term line in the sand at 1.1700, with buy orders triggered when it goes through the level, traders familiar with the matter say. The currency has bounced back with conviction each time it has fallen through that level in the past few weeks.

While economists remain split on whether the ECB will announce a tapering of asset purchases in September -- and a cautious Governing Council next month could spur disappointment to euro bulls -- traders’ conviction seems to be running high.

Witness what happened on Wednesday: the common currency slid more than 50 pips in just 10 minutes following a report that President Mario Draghi won’t deliver a fresh policy message during his upcoming Jackson Hole address later this month. However, it erased those losses completely as interbank and leveraged investors faded the dip, Europe-based traders said.

A very similar market reaction was seen on Thursday after ECB minutes revealed policy makers’ concern that the euro might strengthen more than justified by an improving economy.

Investors don’t seem to be much concerned about exactly when the ECB will announce a reduction of bond purchases; rather, it’s the divergence in policy with the U.S. that they seem to be preoccupied with.

While they are convinced that the ECB will need to act sooner or later to reveal a tapering of asset purchases, they seem skeptical the Federal Reserve will be able to stick with its dot plot given that inflation in the U.S. remains soft. In fact, the odds of a Fed rate increase by the year-end remain well below 50 percent.

While positioning among leveraged investors has turned euro-positive, demand for longs remains, with interbank and real-money accounts looking for a move higher in the euro, said the traders, who asked not to be identified because they are not authorized to speak publicly.

Volatility Skew

The options market also seems bullishly positioned, with the skew in volatility steeper at the longer end than it was a month ago. That suggests demand for euro call options has increased.

Even at the far end of the curve, where euro puts still trade at a premium, the picture has changed considerably. For instance, the premium on one-year risk reversals is 38 basis points in favor of puts, a far cry from the high of 204 basis points seen earlier this year.

Technical Patterns

The euro closed above its 200-week moving average for the first time in three years last week, generating a bullish signal on the charts.

The common currency is also trading above the 38.2% Fibonacci retracement of its drop since 2014. So long as the double-bottom at 1.1613-16 holds on a closing basis, a move toward the 233-week moving average at 1.1970 remains in the cards.

• NOTE: Vassilis Karamanis is an FX and rates strategist who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice

To contact the reporter on this story: Vassilis Karamanis in Athens at vkaramanis1@bloomberg.net.

To contact the editors responsible for this story: Ven Ram at vram1@bloomberg.net, Scott Hamilton