Often when risk appetite flourishes such as it has recently, investors tend to sell low yielding assets such as bonds, and buy higher yielding assets such as stocks. However, since Goldman Sachs ignited the quantitative easing or “QE 2” debate in mid-September, normal market correlations have decoupled. As a result, this has left most market participants glued to movements of the US Dollar.
The Greenback has suffered mightily due to the Federal Reserve’s intent on reviving inflation expectations. Meanwhile, since the last Tuesday’s FOMC minutes, the long-end of the curve has sold-off quite dramatically. This temporary correction in bond yields suggests that the bond market may have fully discounted QE 2.
The Greenback continued to trade lower going into the Bernanke’s speech, despite subsequent stabilization of yield differentials. Shortly after the release of Bernanke’s text on Friday, the dollar briefly reached fresh 2010 lows. The ensuing false-break recovery of the dollar recovery suggests that the currency market may have fully priced-in QE 2 as well.
Simply put, the dollar’s correction was long overdue. Yet, with the largest speculative net-short position in years and bullish sentiment near all-time lows, speculators continue to ignore the fundamentals. In fact, dollar bears began the week accumulating fresh short positions on the back of renewed risk appetite.
Not only was Monday’s sell-off of the dollar short-lived, but China’s decision to raise interest rates caught many traders off-guard. While technically the DXY’s (US Dollar Index) recovery is still considered corrective (while below the 79 handle), there is sufficient evidence that the correction could continue into next week.
The dollar’s rebound has already retraced a quarter of its losses since late August. While this is considered a typical correction within a bear market move, the follow-through move early in Tuesday’s North American session has confirmed the formation of a secondary swing pivot within the EUR/USD, AUD/USD, USD/JPY and Gold.
A secondary swing pivot is characterized as a lower high within an uptrend or a higher low within a downtrend. Most turning points require the formation of a secondary swing to complete or consolidate the trend. While it often takes a series of swing pivots to confirm a trend reversal, the latest price-action is a promising sign for dollar bulls.
According to Elliot wave analysis, the DXY has completed the third wave and has now entered the corrective fourth wave. The second wave was a simple three-wave correction, thus due to alternation there is a high probability that that the current correction could be complex. Meanwhile, only above the 80 threshold alters the wave count and will indicate that a more meaningful rally is in store.
Due to the lack of counter-moves or corrective price-action within the recent move, key retracement levels now become extremely important levels to watch. Oversold dips that exhibit bullish hourly divergence near the 38.2% retracement at EUR1.3560 will likely offer support.
STRATEGY: BUY EUR/USD at 1.3560, risking 1.3505, targeting 1.4186
