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Currency Market Volatility: Technical View Suggests Market Is Basing


Technical setups in the US Dollar Index and associated Currency Crosses can help us identify where we might be in a market cycle and position ourselves accordingly.

Volatility came back with a bang in the third quarter, and it looks like the last two months of 2011 will continue to whipsaw the markets with headline-driven macro trading, moving prices around quickly. After a down 7% month in the S&P 500 in September, October burned the new shorts and those who took risk off by jamming higher by more than 10% in what was one of the best monthly returns for the broad stock market index in decades. Correlations and volatility have remained at elevated levels, and this is bringing the macro outlook into even greater focus for traders and investors.

When analyzing the macro environment, and understanding what is driving this "risk on / risk off" market, the currency market is critical because it is the largest in the world. The US Dollar Index is a great barometer for risk on and off because a weaker US dollar is generally viewed as favorable for "risk" and higher asset prices, while a stronger US dollar can be associated with a flight to safety and "risk off" environment. Technical setups in the US Dollar Index and associated Currency Crosses can help us identify where we might be in a market cycle and position ourselves accordingly.

In the first chart below, you can see how the recent DX (US Dollar Index) weakness coincided with an equity market rally with pretty clear inverse correlation. The DX pulled back sharply from the 80 level, and ran the stops set below the 200 day moving average around 76. This sharp move set the stage for a dramatic reversal back to the upside for the US Dollar Index. The S&P 500 rallied over 200 points from a low of 1075 in early October to test the 200 day moving average around 1275. So far it has failed back below that level, and it certainly seems like the market is back in "risk off" mode.

US Dollar Index running the stops below 76:

Click to enlarge

The euro is a large weighting in the US Dollar Index and obviously the European currency crisis has been a dominant theme in currency trading this year. Again, like the US Dollar Index and S&P 500, this market ran the stops around the 200 day moving average, and reversed sharply. This occurred on the spike above 1.40 in the euro, and it has now quickly sold back off to the mid 1.30s. This failure of the euro above 1.40 and the 200 day moving average proves that will be a formidable resistance level, and the crisis in Europe is far from over…

Euro running the stops above the 200 day moving average:

Click to enlarge

Looking at a longer term (weekly) chart of the US Dollar Index below, we can see that the rally stopped right at the 200 week moving average around 79. You can also see how 75 has been solid support level not only this year, but back in 2009 as well. This certainly looks like a market that is basing and about ready to turn up. A move back above 79 would turn the longer term trend higher and as you can see, would provide some pretty significant upside to the US Dollar Index, which unfortunately, could bode for a prolonged period of a "risk off" environment. Trade accordingly and be careful out there!

US Dollar Index Weekly…Double Bottom at 75…start of Wave 3 up?:

Click to enlarge

Position in EUO.
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