Euro Rally Shows Signs of Fatigue on Risk of Second Virus Wave

(Bloomberg) --

The euro has proved a key winner from easing virus fears around the world, with a startling 5% surge in the past month. It may now become a victim of its own success.

The common currency climbed to a three-month high versus the dollar after the Federal Reserve’s dovish views met expectations, yet gains proved short-lived. It was outdone Thursday by traditional havens the yen and the Swiss franc, as the greenback climbed against most other peers.

That left the euro heading for its worst four-day run versus the Swiss currency in nearly two years, as worries grow about a resurgence of the Covid-19 pandemic. Data has shown a rise in infection rates in some U.S. states.

“The risk of a second wave of the pandemic may become the main determinant of the euro-dollar,” said Neil Jones, head of foreign-exchange sales to financial institutions at Mizuho Bank.

The common currency may extend a decline unless the region’s lockdown restrictions keep on easing and governments unanimously approve a proposal for a recovery fund. And with investor positioning now more balanced and technical charts flashing warning signs, the market is unlikely to chase any gains higher.

The currency went on a run where consecutive fresh highs were hit, a sign of a market caught wrong-footed, as the move was flow-related and not based on fundamentals. If anything, risks such as Brexit trade talks were overlooked as hedge funds chased the market higher in both the spot and options market.

Investors weren’t convinced initially that the currency could escape from its $1.08-$1.12 range of recent months, and kept options bets rather reserved. As equity ebullience kept spilling over in the currency space, hedge funds added options exposure that looked for another leg higher to materialize.

That drew bets for a bigger rally above $1.20, as well as options with strikes at $1.15 and $1.16, according to Europe-based traders who asked not to be identified because they are not authorized to speak publicly. These so-called reverse knockout bets looked for the euro to gain, but not above the strike levels.

Correction Imminent

As positioning is now more even, investors may not be looking to aggressively push the market higher as they did earlier this month. Added to that, charts show a deep correction may be imminent. Momentum indicators like the Commodity Channel Index have already sent a bearish signal, while the currency’s relative strength index is diverging from spot price action, a sign of a reversal to come.

The euro traded little changed at $1.1383 as of 10:15 a.m. in London, following a 0.4% drop earlier. Key levels to the downside include $1.1241, the June 9 low and $1.1163, the high on March 30. The March 9 and year-to-date high of $1.1495 is the main interest in the event of further gains.

Investors should also take note that equity support may soon fade. Half of Stoxx Europe 600 companies are trading higher than the average prices that analysts estimate in the next 12 months after a rapid rebound, which is the second widest divergence after the spring rally of 2015.

• 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

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