Projecting the Euro's Downside

 | Jan 17, 2012 | 1:30 PM EST  | Comments
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This commentary originally appeared at 11 a.m. on Real Money Pro – Click here to learn about this dynamic market information service for active traders.

Monday was a holiday in the U.S., but for the rest of the world it was business as usual. After Friday's downgrades of nine euro zone countries by Standard & Poor's, it was only fitting that on Monday, the bonds of the European Financial Stability Facility were also reduced by a notch by the same ratings agency, from AAA to AA+. EFSF bonds are still rated AAA by Moody's and Fitch.

The EFSF was created to stabilize Europe by bailing out troubled countries such as Greece and Portugal by issuing bonds backed by the combined strength of the euro zone, including AAA-rated countries such as Germany. According to S&P, Finland, Luxembourg and the Netherlands maintain their AAA rating but have been placed on negative credit watch; France and Austria lost their AAA ratings on Friday.

I don't believe the downgrade itself will have a significant impact, as it was highly anticipated. The entire world is engulfed in financial turmoil. It would be different if these issues were specific to one country or region, but because of the intertwined nature of the financial markets, "safe haven" has become a relative term.

So where is euro going? Lately, the word "parity" is being tossed around like quite a bit, and technically speaking, there is some support for this view. Just keep in mind that in the same thing occurred in 2010; back then, nearly every analyst on the Street was calling for euro parity to the U.S. dollar. Many were caught wrong-footed when the euro reversed course and climbed from its low just under 1.19 (A) and ran all the way to 1.49 (B).

Euro vs. Dollar, Monthly
TradeStation

That move created a major low (1.1875, a five-year low) and a major high (1.4940, a two-year high) in the euro vs. the U.S. dollar. Using Fibonacci analysis, we can measure that move from low to high, in order to project potential downside targets for euro.

The June 2010 low of 1.1875 (A) is an obvious target, as it represents a 100% retracement of the move, but where will euro find support if it moves beneath that level? To find the answer, we can use Fibonacci projections, which can be used to create targets for moves that retrace beyond 100%. One of those projections, representing a 1.618% retracement of the rally (shaded blue), places the euro just a few ticks below 1.00, which represents parity between the unified currency and the dollar.

Despite all the turmoil, there are still reasons to like the euro at these levels. First, the market is still heavily short the euro, to the tune of 155.195 net contracts, according to the most recent CFTC data, so there is still plenty of opportunity for a short squeeze.

Second, last week's S&P downgrades were highly anticipated. It's not as if markets were shocked, as rumors of a French downgrade have been making the rounds for weeks.

Finally, a Greek exit from the euro zone would be viewed by many as a positive event that would likely drive the euro higher. S&P's head of sovereign ratings appeared on Bloomberg TV yesterday, saying a Greek default was imminent, and such an event could move Greece one step closer to the exit.

Taking these possibilities into account, the euro could move higher in the short to medium term. But even if a short squeeze does materialize, the resulting rally could be short lived. If European leaders continue to flail at solutions to the crisis, further downgrades will come, and then parity becomes a realistic target.

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