What Can We Expect from a Euro Rally? (by Closing Basis)

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Ok, so if the rest of you are anything like me, you're wondering where the market is going to go when it is at bullish extremes and screaming for a sell off/pullback, yet at the same time, it looks like the Euro is getting ready to rally and the US bonds getting ready to sell off which should encourage further upside in the indices.

 So, I threw together a 3yr comparison between the S&P500, TLH (10yr notes), and FXE (Euro ETF).  I've made some interesting and consistent observations so check it out.

Euro rally effects - Jan 21, 2012

Now, in the chart, I'm concentrating on the Euro (FXE) and what effect a Euro rally has on the market specifically, but also 10yr notes.  You'll notice a series of vertical red and blue lines, these mark approximate crosses of Euro price over its 50EMA.  Now that I'm done, these weren't as significant or helpful because there were multiple crossovers while the trend remained intact (they likely held at longer-term averages).  That is the nature of MA's though (whatever they type).  They are lagging indicators. 

However, I find the soonest signals you usually ever get are trend line breaks.  I drew in a few of the larger trend line breaks/trend reversals.  For the most part, the Euro looks similar to the SPX.  Twice we've had very strong divergences between the Euro and SPX.  The last one was between Dec '09 and Apr 2010.  In that case, the market moved to come back into line with the Euro which we all affectionately refer to as the "flash crash". 

I'm not saying that's what happens now (though it could and would be great for my short positions).  So to get "generally" back in line, either the market should drop or the Euro should climb.  It seems that the market is preferring the Euro climb given by the trend line break.  Notice the MACD below (based on the FXE chart).  Euro rallies have usually occurred below the MACD -2 line, so that is consistent with this possibility as well, never mind the large COT commercial long position.

So, if indeed the Euro is rallying, what should we expect from the market?  Looking back over the last three years, I noticed something important.  The Euro has had plenty of rallies in uptrends and downtrends.  The effect on the SPX (I've highlighted them all in blue) seems to be dependent on what the trend of the SPX was at the time.  Whenever the Euro rallied hard after the SPX had ALSO been selling off, that was when we saw large SPX rallies.  However, whenever the SPX was already in an uptrend, the SPX did rally, but not nearly as much.  I would postulate that the reason for this is that there were a lot of shorts to cover in the SPX when it was selling off while when SPX was in an uptrend, it was still relatively bullish and the pressure to short cover was not there nearly as much.

One more thing.  On the bond chart, I highlighted the selling trends to look for patterns.  The last two happened to be generally in the "strong months" of the year for the market (Oct-Apr).  Once again, in 2011, the TLH broke its uptrend line in October.  Do we have a few more months of bond weakness?  Maybe we even sell down as far as 125.  That was the last serious support level and would establish a range. 

This would be consistent with typical consolidation phases.  The last thing to note about TLH that I've seen is the higher major lows.  In a perfect correlation, we should have seen bonds make a lower low than April 2010 while the S&P500 made a higher high, but that didn't happen.  This tells me that investors are still preferring safety to risk-chasing over the long-term until the charts tell us otherwise.  Given the extendedness of the SPX here, I would expect to see some sort of pullback or retracement, but if the Euro strength persists, we could see another leg higher yet to the summer highs for a start after which some reevaluation will be required.  Cheers.