U.S. Dollar Index Reaches Major 50% Level; Euro Survives Stress Tests

The U.S Dollar Index had a roller-coaster ridethis week although it managed to finish only slightly lower.

The U.S Dollar Index had a roller-coaster ride this weekalthough it managed to finish only slightly lower. Based on the November 2009to June 2010 trading range of 75.03 to 89.22, this market is now testing amajor 50% level at 82.12.

Over the past two weeks, the pace of the decline has slowedas the market approached the 50% retracement level, but following this week’sinside trading range, may be set up for an acceleration to the downside. Abreak through 82.12 is likely to trigger a sharp break into the nextretracement level at 80.45.

Traders should turn their attention to this index this weekbecause of the possibility of stronger than average volatility and thepotential for a support base to form between the 50% and 61.8% retracementlevels at 82.12 to 80.45.

The Weekly Euro had a volatile, two-directional trade thisweek, ping-ponging between a 50% support level at 1.2783 and a 61.8% resistancelevel at 1.2998. Technically, the weekly chart formed a closing price reversaltop, but will have to trade through 1.2732 to confirm it. A confirmation ofthis pattern is likely to trigger a 2 to 3 week correction back to 1.2452 to1.2316.

A failure to confirm the reversal top and a close over1.2998 will be a bullish signal. Look for an acceleration to the upside if thisoccurs since the chart indicates no major resistance on the weekly chart until1.3510.

On Friday, the Euro was up in early session trading in acontinuation of Thursday’s strong rally before jitters about today’s stresstests triggered a profit-taking correction. From an early session high at1.2965, the Euro broke to 1.2793 shortly after the New York opening.

The EUR USD spiked to 1.2910 immediately after stress testresults began being released, but sold off quickly as traders were disappointedwith the results. Although only a small number of European banks passed theirstress tests, investors remained skeptical about the methodology used by theregulators. Many viewed the guidelines used as too easy on sovereign debt.

As expected, Germany’sHRE, Greek’s Atebank and Spain’sBanca Civica failed their tests, but most banks passed even in hot spots suchas Greece and Spain.

The biggest concern for investors was that stress testsexcluded the possibility of sovereign debt default. Sovereign debt held inportfolios was distinguished from sovereign debt held to maturity. Debt heldfor trading is expected to be marked to market; debt held to maturity is not.

The problem with this separation into two different types ofdebt means that it is possible that losses by banks will be underestimated. Thiscould hurt the financial health of European Banks and undermine the credibilityof the banking system.

The concerns being raised by investors put pressure on theEuro at the mid-session, but a late session rally in U.S. equity markets triggered ashort-covering rally in the Euro, pushing it higher for the day. While the newsabout the bank stress tests is unsettling, risk takers decided that nothing outof the ordinary was revealed so traders turned their attention to higher riskassets like U.S.stocks in what can best be described as a relief rally.

The British Pound rallied sharply higher on Friday versusthe U.S. Dollar and the Euro. Friday’s rally was ignited by the news that theU.K. economy grew almost twice as much as economists forecast in the secondquarter in the fastest expansion for four years. The strongest gains were seenin the services, manufacturing and construction sectors.

The bullish economic news out of the U.K. was damaging to the U.S. Dollar because itwas solid proof that the economy was recovering at a time when the Fed wasforecasting a weaker GDP for the U.S. Friday’s report may be theevidence the Bank of England needs to begin hiking its historically lowbenchmark interest rate. In the meantime, the Fed is pondering applying morestimuli as well as renewing its quantitative easing program. Treasury markettraders are already pricing in a rate hike for September 2011, this is up froman earlier forecast of Spring 2011.

The improving economy and the possibility of asooner-than-expected rate hike make the GBP USD a more attractive investment atthis time. Technically, the Pound/Dollar had an inside week which indicatesimpending volatility. The strong close puts this market in a position to takeout the April swing top at 1.5523. A breakout above this level may run intoselling pressure inside of a major retracement zone at 1.5635 to 1.5967.

Although the initial reaction to the stress tests wasbearish for the Euro, traders quickly realized that the news was already in themarket. In my opinion, European Central Bank President Trichet’s commentearlier in the month that banks would need to raise capital and a rumor lastweek that eleven banks would fail the test was spot on. Today’s report revealedthat seven institutions didn’t have enough capital and may need to raise morethan $4.5 billion.

Analysts around the globe are saying that the stress testsweren’t stringent enough and that the release of the results failed toalleviate market concerns about the banking system’s vulnerability tosovereign-default risk. Nonetheless, investors spoke today by trashing theDollar and rallying stocks, this could be an indication that they have put thetests behind them and are turning their focus on the global economic recovery.This means that economic reports are likely to carry more weight in the weeksahead.