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Has the euro turned around?

Srinivasa Sundararajan

LAST week, we wrote that the common currency could have traded a short-term bottom. The structure indicated that the euro could unwind the fall from 1.0088 to 0.8845.

We were looking for a break and close above the critical 0.9250-level for at least two days in a row. This short-term bullish outlook was based partly on the analysis of investment flows, especially among European investors.

A combination of investment flows and Elliott Wave analysis provides an idea of what one could expect of the underlying currency. Our analysis shows that when the flows were overweight on the euro, it crashed all the way below parity, while the fundament als cried for a revival of fortunes. With the bears controlling the euro, the investors turned neutral. This strategy lasted as long as it traded above the 0.9665-support. As investment flows turned underweight on euro, it was hammered to a historic low of 0.8845.

The dramatic and yet unexpected turnaround in the euro's fortunes last Friday caught the shorts unaware. As the bears hurried for cover, the common currency zoomed to test 0.9345 in late New York trade and closed above the 0.9300-level.

Euro bears would vividly remember that most of the previous recoveries have been full of false starts and, therefore, they would hope that the rally would come to a naught between 0.9450 and 0.9665. Fair enough. Given its reputation, it is a bit difficul t to accept that Friday's rally is the beginning of a major reversal in the fortunes of the euro.

How does one integrate the investment flows into wave analysis? Usually, consensus and wave structure do not go hand in hand. Once the underlying instrument trades a bottom (top), which could just be possible in the case of the euro, one witnesses a powe rful and impulsive upside (downside) breakout, which

catches almost everyone by surprise.

The shorts (longs) squeeze (liquidation) often provides a perfect platform for a trend-reversal. When this takes place, a majority of the market players continue to call the trend reversal as merely corrective and hence an opportunity to sell (buy) at hi gher (lower) levels.

Such reversals usually take place when investors are underweight (overweight) on a currency and, hence, the inability to perceive a reversal which is in the making.

With investors turning underweight on the euro after a break below the 0.9665-level, I believe that the first sign of a medium-term bottom in place would be a break and close above the 0.9665-resistance for two weeks in a row.

Since reversals are usually very fast and sharp, this resistance must happen within the next two or three weeks. If it does not, the euro would be subjected to severe selling pressure.

A break of this critical resistance would give a much-needed fillip to the common currency. If it does happen, investment flows would once again switch to neutral weight on the euro. Ideally, an overweight euro strategy would happen when the euro stabili ses above the 1.0150-levels.

Does wave analysis place a major bottom at 0.8845? Although we are tempted to see it that way, the slope of the fall from 1.0912 to 1.0417 and 0.9665 puts a break on that optimistic outlook.

When a major bottom unfolds, the degree and the slope of the decline in the underlying instrument lacks an impulsive structure. The decline is usually time consuming, quite volatile and messy.

For example, let us look at dollar/yen. The rally in the dollar to 147.75 yen in August 1998 retained all the conditions mentioned above. At that time, the consensus evolved firmly in favour of the dollar testing 160.00 and investment flows were underwei ght yen, which happened precisely at a time when the wave structure called for a major top in the dollar! What happened next is history as the dollar unwound the gains from 110 to 147.75 in less than 25 per cent of the time it took to rally.

The euro's fall from the above-mentioned levels lacks

most of these characteristics. In addition, the rally to 1.0912 and 1.0417 was impulsive. These recoveries were made possible on the back of investment flows being overweight and neutral on the euro. If one were to compare this recovery with that off 0.8 845, the key difference is the underweight investment flows.

Since the wave structure ideally trades a bottom at a time when the flows turn underweight, it leads us to believe that this rally may be different from the earlier ones.

If Friday's recovery were to sustain going forward, it would be natural to expect a rally to 0.9665 and eventually to 1.0417 within 50 per cent of the time it took to evolve to 0.8845. As long as it does not happen, the rally, unfortunately, will be sold for a new low.

To conclude, the events that unfolded on Friday night may lead us to feel that there is light at the end of the tunnel. Is it real or just an illusion? Only time can tell!

(The author is a Treasury Executive in a leading foreign bank. Responses can be mailed at drsrinisundar@yahoo.com)