Euro Rally Ripe for Reversal

NEW YORK (TheStreet) --The euro is continuing its latest bull run higher, gaining against most of its major counterparts and hitting levels against the U.S. dollar that have not been seen since the middle of June.

The rally in the euro has been propelled by comments from the German Bundesbank, suggesting that policymakers in the eurozone are not predisposed to maintaining interest rates at their historical lows and that rates could rise, if upside pressure is seen in consumer price levels. Those statements jarred some sections of the market, as this marks a direct contradiction to previous comments made by European Central Bank President Mario Draghi, which signaled a prolonged intention to keep monetary policy accommodative as a way to boost the struggling eurozone economy.

Rallies in the euro have been broad based, with valuations in the EUR/JPY rising above the 131 level, as well. But the next question going forward is whether this rally is sustainable, given the rising Treasury yields seen in the U.S., little evidence of progress in the eurozone's elevated unemployment rate, and the growing likelihood that the Federal Reserve will begin to enact policy changes that will strengthen the U.S. dollar.

Given this set of event risks, the CurrencyShares Euro Trust ETF ( FXE) starts to look much more like a "sell," at current levels, with recent weakness in the PowerShares DB US Dollar Index Bullish ETF ( UUP) looking attractive as a buying opportunity.

Rate Outlook in U.S., Eurozone

The prospect of rising interest rates could be bullish for the euro, as increased yields make currency positions more attractive. But with yields in the bellwether 10-year Treasury note hitting two-year highs of 2.9%, it is clear that the market is pricing in an increased chance the Fed will start to roll back its programs in quantitative easing.

The latest analyst surveys show a majority expecting the Fed will cut its monthly asset purchases by $10 billion, and the next indication of whether these projections are accurate will come on Wednesday. This is when the minutes from the July FOMC meeting are scheduled for release.

The report will offer key clues about the Fed's position on the strength of the economy. An upbeat assessment will lead to renewed speculation that the U.S. is positioned strongly enough to begin making reductions to monetary stimulus. If we do, in fact, see September tapering, expect to see a massive surge in the U.S. dollar -- especially against the euro, given the relative weakness we have seen in the last two months.

Recent economic data in the U.S. have been mixed, and this does increase the chances for delays in policy changes from the Fed. But when we look at the broader environment, all indicators suggest that the Fed will be the first of the major central banks to unwind its stimulus programs.

Second-quarter GDP in the eurozone turned positive, at 0.3%, marking an end to 18 months of declines. But it is important to remember that these improvements have been largely unbalanced, with peripheral nations (Spain, Portugal, Italy, Ireland and Greece) not even close to approaching positive territory.

Unemployment remains elevated at 12.1% across the region, and all of this points to a diverging rate outlook and a weakening currency when compared to its U.S. counterpart. Use the latest strength in the CurrencyShares Euro Trust ETF as an opportunity to sell.

Euro Chart Perspective

The CurrencyShares Euro Trust ETF is trading above its 100-week exponential moving average, which is suggestive of positive momentum. But risk to reward prospects remain limited, given the price proximity to the June highs at 132.90. Technical bias is lower at this stage, unless we see a weekly close above this key historical resistance level.

At the time of publication the author had no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

Richard Cox is based in China, and has lectured at several universities there on international trade and finance, focusing primarily on macroeconomics and price behavior in equity markets. His articles appear on a variety of Web sites, including MarketBulls.net, Seeking Alpha, FX Street and others. Investing strategies are based on technical and fundamental analysis of all the major asset classes (stock indices, currencies, and commodities). Trade ideas are generally based on time horizons of one to six months.

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