Is EURUSD or the S&P “Right”? (SPY, UUP, FXE, EWQ, EWP)

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Abigail F. Doolittle: Something very interesting has been happening since early December and that is a parting of ways between the risk assets and the risk currency with the former represented by the S&P (NYSEARCA:SPY) and the latter by EURUSD (NSYEARCA:UUP, NYSEARCA:FXE).

Specifically, both the S&P in purple and EURUSD in blue have traded in a highly correlated fashion over the last two years with the actual correlation as high as 90% this past fall according to one of the big banks and such a similar trading path has come under the shape of a large Symmetrical Triangle as can be seen above.

Such a pattern represents consolidation and “a picture of “doubt” awaiting clarification” with investors probably wanting to know whether another proverbial shoe will drop from the credit crisis of 2008 and/or whether the sovereign debt and banking crisis will push the financial system and/or the global economy over some sort of edge.

In looking at the S&P’s breakout above the Symmetrical Triangle, investors seem to believe that the credit crisis is over and that the eurozone sovereign debt crisis has or will be successfully contained.  What baffles me, though, about such an upside breakout is when and where the clarity came from to give investors reason to dismiss those risks around the risk assets.

There are any number of excellent summaries out there about these risks in the FT, WSJ and elsewhere, but Matts Persson of The Telegraph did a nice job recently of simplifying the possibilities around the eurozone crisis in the “good”, the bad and the ugly.

According to Persson, the “bad” scenario for the eurozone includes:

(1) An inevitable recession in the region,
(2) Greece will default in March if it does not receive the next tranche of its bailout,
(3) France (NYSEARCA:EWQ), and a big part of the bailout backing, could be downgraded, and,
(4) A eurozone bank could collapse unexpectedly.

Furthermore, Persson lays out “The Ugly” in outlining the possibility of (1) widespread eurozone downgrades, (2) Spanish (NYSEARCA:EWP) bank collapses that would require EU/IMF bailouts, and (3) possible bank collapses in France and Italy on exposure to the weaker eurozone members.

Even if “the “good”” comes true with the ECB stepping up more to prevent any sort of “deep freeze” in the banking system along with there being some bailout cash left, such potential “positives” do not prove that the bad and the ugly could not happen still.

Interestingly, it is the EURUSD itself that reflects this overhang of what could go wrong, very wrong, as in bad and ugly, with its downside breakout from the large Symmetrical Triangle that it has shared with the S&P over the last two years.

As can be seen in the chart on the previous page, EURUSD is trading down and out of that Symmetrical Triangle and perhaps to the pattern’s downside target of parity in what appears to be a bearish Descending Trend Channel as the S&P climbs higher on what looks like a bearish Rising Wedge even though it is built of a bullish trend.

So even though EURUSD and the S&P have been trading in separate directions for about six weeks, each is making its respective move down and up on bearish technical aspects and this may suggest that it will be the S&P to join the EURUSD when the two do sync back up as seems rather likely.

That being said, the S&P has been “right” more often than not in the past and maybe this means EURUSD’s Descending Trend Channel is actually a bullish Falling Wedge and something that could allow it to meet the S&P somewhere in between the current departure as the S&P fulfills its bearish Rising Wedge, even though this would make little sense, or maybe the S&P’s bearish pattern fails and the EURUSD simply follows it up.

Considering, though, that the EURUSD has been trading down steadily this year on no real news, it seems that the market is trying to price in the possibility of the bad that it “knows” is coming with the ugly being more about sudden spikes down.

Should those EURUSD expectations for the bad materialize, it is unlikely to offer EURUSD a relief rally and it is even less likely to help the S&P climb higher and it such a potential scenario that tells us, this time, EURUSD may just be “right”.

Sam’s Stash, Gold and the S&P

Well for fun, let’s throw the dollar (NYSEARCA:UUP) index into the mix as shown in the chart on the following page to see what it might say about the divergence between EURUSD and the S&P.

Interestingly, the S&P has been tracking the dollar (NYSEARCA:UUP) index up and something that was suggested as a possibility here in October 21’s Operation Rebalance.

Today, my fundamental views have shifted a bit, though, and while the buck continues to look like it is going to rebound throughout 2012, it is probably going to be one safe haven status as opposed to some sort of genuine recovery.

What may take the dollar index higher is the fulfilling bullish Falling Wedge with a target of about 88.

Now maybe a genuine economic recovery will appear in the months ahead and that will be the driver behind a stronger dollar, but the extreme downside target of EURUSD’s Symmetrical Triangle – parity – that EURUSD is currently confirmed to move toward suggests dollar strength may be more about its safe haven status.

Should this turn out to be true, dollar strength on safe haven status will signal risk off and something that tells us that the S&P’s current breakout from that Symmetrical Triangle may reverse back down as it joins the descending path of the risk associated with EURUSD.

Thank you for taking the time to read this week’s piece and have a relaxing long weekend.

Courtesy of Abigail F. Doolittle, Peak Theories Research

Posted with permission of author by Wall Street Sector Selector