I think the best analogy to describe to someone who doesn’t trade or hasn’t got any experience with financial markets, what is affecting price action, why do prices move up and down, is to offer an example from the world of physics and the nature of an electron.
An electron, is a particle and a wave of energy at the same time, it has got a dual nature. As a particle, more or less we can predict its trajectory but as a cloud of energy, it is becoming impossible. Therefore, if we try to predict where an electron will be the next second, we can guess that it will be roughly in a specific area, rather than an exact point.
Exactly the same principle applies for asset prices in financial markets. Everything depends on fundamentals, it is actual economic indicators that drive prices and tell us exactly the fair price of an asset but, at the same we also have sentiment involved, behavioral factors and expectations about the future which can cause serious abnormality, since we know humans often overreact!
This year 2017, has been more difficult to trade, especially for FX, because it has been driven mostly by expectations and sentiment and less on fundamentals, to put it in another way the carry trade wasn’t a major driver of prices, as it has been in previous years.
However, we can still uncover opportunities and high probability set ups if we combine our fundamental outlook together with technical.
In the previous week, the EUR has been weakening against other major currencies.
Possible future ECB policy, leaving the door open for an extension of the current QE and dovish rhetoric from Mario Draghi and other ECB members has caused the German yields to move slightly lower, despite tapering of the QE next year.
Take a look at the 2y German yields.
The 2y yields technically are right on the trend-line, finding support and we will be eagerly looking for developments over the next few weeks and evaluate the reaction of buyers vs sellers in this area.
But the yields themselves in absolute terms doesn’t mean anything, please take a look at the German differential against the US 2y yields.
We can clearly see that the yield differential is strongly in favor of the US and has been rising further the last week. What do you think is more likely to have happened to the EURUSD pair?
This is a market profile chart of the EURUSD.
We can clearly see that the move lower in the EUR is positively correlated with the move higher of the US-German 2y spread and that exactly is going to be the catalysts that will drive prices next.
In the short term, we are prepared for a potential move towards the 1.15 level, where we would be happy to evaluate potential long positions in favor of the EUR. We say this since we believe that the US FED will not be able, in this international financial environment, to begin a gradual hiking cycle. The Trump administration is against a strong dollar policy and we also believe that the so called “Trump trade” will fade, as the much anticipated tax cuts or any other measure will be meaningless and won’t have a material impact in the US economy. On the contrary we see further risks ahead and the spread will not continue to rise indefinitely.
Technically we can also notice on the profile chart the recent rejections and the thin volumes at the 1.17 area, where the sellers took control thus, in the short term, we are interested for any potential longs only above 1.17, if that area is accepted and we see volumes building up again.
However, the EUR didn’t only move lower against the USD but against the GBP too.
Would you like to guess, what happened to the GBP-German 2y yields differentials?
Take a look below.
You can see that the yields spread spiked higher in favor of the UK. What happened to the EURGBP? Here, is the market profile chart.
The EUR moved lower of course against the GBP, as it was hard to break the confluence of resistances around 0.8940, as well as the High Volume node that is exactly on that area. Our target is the bottom of the balance around the 0.88 area. That depends of course on the yield differential over the next few days.
What about the GBP against the USD?
The spread is slightly in favor of the USD and this justifies the move higher of the USD against the GBP recently but, we can see that the spread struggles to break higher and price is consolidating inside this range. Of course, many depend on ongoing Brexit negotiations but we feel that the spread might start correcting lower.
This is impacting the GBPUSD pair. Let’s take a look at the market profile chart.
Definitely, we will not be looking to sell the GBP against the USD at the bottom of that larger balance and the possibility of a correction in the spread.
In the short term, we will be looking for a small speculative position to the upside, around these levels, provided of course that the spread stays that way. But even if we have a correction lower in the GBPUSD, I am more biased to buy the GBP vs the USD, due to the yield spread and other fundamental factors that have to do with the US economy mostly.
In this article, we have shown you how fundamental factors, such as the interest rate differentials, can provide clarity and offer you a clear vision about what is likely to happen next. Combining fundamentals together with proper technical, can help you discover high probability setups, with good risk/reward characteristics. Over the next few weeks please pay attention to the short term spreads, since that is going to drive currencies and determine price action.
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