Last Thursday saw the 7th biggest one day gain for the euro since its inception. What is interesting is that global stocks declined that day, meaning that in a risk-aversion move, we should have seen a corresponding decline in EUR/USD.

Also that day, the pound had a big gain while the aussie fell. How can we explain this?

First, last Thursday was the day that European banks rolled over their 12 month loans the ECB had given them last year in an effort to support markets (the ECB had been offering unlimited cash for 12 months). The banks had to roll these 12 month loans into new 3 month positions and later 1 week positions. So, what’s likely is that there was a big demand for euros as banks looked to square their books.

I also wrote back on June 19, after China announced that it was allowing the yuan to trade in a 0.05% daily band (de-peg from the dollar), that it was in China’s interest to see EUR/USD rise since beginning in July 2008, China’s peg to the USD had caused the yuan to appreciate against the euro. This appreciation naturally would have a negative effect on China’s exports to Europe, its largest trading partner, as Chinese good became more expensive to the region.

Since June 19, the euro has appreciated against the dollar even though the S&P 500 is down over 8% in the period, exactly the opposite of what you would expect to see. But what’s also interesting is that the aussie has depreciated against the dollar over that time as you would expect to see when risk comes off the table. So, the question becomes, why is there an apparent divergence in how EUR/USD and AUD/USD are moving?

China’s Interests

Remember that China has about $2 trillion of reserves held in dollars and because the yuan is not freely convertible, many of its international transactions are carried out in dollars. Also remember that China exports to Europe and imports (mainly raw materials like iron ore, copper and coal) from Australia. So, if you’re China, the ideal situation would be to see EUR/USD rise (which in essence means the euro is appreciating against the yuan, making Chinese goods cheaper and more competitive)) and also to see AUD/USD fall (because that drives down the costs of Chinese imports from Australia).

What about the pound? Well, if EUR/USD had appreciated without a corresponding increase in GBP/USD, it would have caused the euro to also appreciate against the pound (which is the last thing the EU wants because of the sizeable exports to the UK). So, it looks as if the pound went along for the ride as the euro gained on the USD last week even though some believe that England’s announced austerity/debt reduction program was getting a favorable reaction from investors.

What this all means is that the correlations we’ve come to depend on, i.e. risk aversion = stronger dollar and vice-versa, may not be as reliable if China is really determined to pursue a stronger euro and a weaker aussie against the yuan.

Bloomberg has been kind enough to point out a reverse head and shoulders formation on the daily EUR/USD chart (outlined in blue). What’s interesting is that the neckline is pretty much at the 38.2 retrace level of the last big decline in the euro this year. The suggestion is that if this neckline is broken, it will be taken as a bullish sign for EUR/USD.

I’m looking at things differently since I still believe that the euro will decline as stocks sell off on the expected weakness in the US economy. The way I see it, from the level where the euro is now (around 1.2537), there is recent evidence (from May 24) of sellers protecting their short positions.

©2010 FX Instructor Forex Blog - For Traders, By Traders. All Rights Reserved.

.