EUR/USD, Euro Stocks Primed for ECB: Will Draghi Deliver?

2016-03-09 15:02:00

Talking Points:

- The European Central Bank meets tomorrow morning, and many traders have begun to factor in the potential for an increase to QE, a deeper cut to the deposit rate, or both. But these may have unequal impacts on risk markets, as we’ve seen over the past few months. We explain further below.

- We go over two setups to look to trade the ECB announcement in either direction.

- With three major Central Bank announcements over the next week, markets will likely remain volatile. Make sure to address risk management, and if you’re looking for intra-day trade ideas, check out our SSI indicator (explained here).

Today’s article can be considered an evolved redux of the article that we had published in November just ahead of the December ECB meeting. Going into that meeting, hopes were high for an increase to European QE. But we didn’t get that increase to QE at the December ECB meeting, and instead only saw a deeper cut of the deposit rate further into negative territory. This disappointment roiled markets, and it sent the Euro flying by over 470 pips against the US Dollar, and this, in-turn, dented stock prices throughout Europe.

So, deductively this highlights a couple of important themes: Central Bank QE remains as one of the most bullish elements across markets for Equities, and also stocks like more QE, and stocks do not like deeper negative rates. The chart below of the German DAX illustrates this relationship as it’s played out over the last few months:

Created with Marketscope/Trading Station II; prepared by James Stanley

Perhaps not coincidentally, the lows in European equities came in on February 11th, which was the second day of Ms. Yellen’s testimony in front of Congress. During that testimony, markets inferred a dovish read from the head of the Fed, and this largely brought stock prices back to life after a tumultuous two week-period that saw new short-term lows come in. But since that 2/11 low, stock prices around-the-world have been ripping like its 2011. So how, might one ask, could Ms. Yellen’s Congressional Testimony be construed as a positive for European stocks?

Well, the Fed refraining from a hike in March or later in the year, as Ms. Yellen had implied, could remove considerable pressure from equities around the world. As we had identified just ahead of the New Year, interest rates in the United States and the prospect of tighter monetary policy out of the largest national economy in the world was too much to bear given the threatening backdrop facing global markets. So the prospect of the Fed backing off along with the premise of the European Central Bank stepping up to the plate has helped to bring Euro assets right back to their bullish ways. On the chart below, we’re looking at the EUR/USD, and notice that this recent short-term top came in on that same February 11th morning that set the near-term low in stock prices.

Created with Marketscope/Trading Station II; prepared by James Stanley

What’s the Trade?

Predicting news announcement is notoriously a bad way to go about generating trade ideas. Frankly, news presents a double-barreled shotgun of risk. A) You don’t know what the news will be, and even if you did b) you don’t know exactly how price action will incorporate that news. So rather than hoping and guessing, which are generally terrible trading strategies, traders can look to the chart to try to find setups. And, of course, as always the case with major news announcement – if you’re not comfortable or don’t want to take on the risk, don’t’ trade it.

We covered a similar strategy built around news volatility earlier in the week in regards to GBP/JPY, entitled News Can Help, News Can Hurt. The premise being that, given that news releases are an unquantifiable amount of risk with the simple premise that volatility will increase around the event, traders can look for positive risk-reward ratios in order to try to take advantage of that volatility.

Moving into tomorrow’s ECB announcement, most Euro pairs are putting in bearish price action formations. These recent price action swings can allow traders to take a short position ahead of the news with a positive risk-reward ratio so that if the ECB doesn’t deliver, the loss can be mitigated as new highs are made. But if they do deliver, the trader can potentially look for a larger profit targets than the risk they may have to put up to get in the position in the first place.

On the chart below we’re looking at the current setup in EUR/USD. Notice that as of today, the daily chart is working on an evening star formation. This is a bearish reversal pattern, and should it complete at the close today, then traders can look at getting short off of this pattern ahead of the ECB. This would allow a trader to get a stop above yesterday’s doji/inverted hammer formation, and should the ECB deliver the trader can look for deeper support levels to come into play at 1.0824, 1.0757 and then at 1.0600. But if they don’t deliver, the trade can be cut as the Euro ascends.

Created with Marketscope/Trading Station II; prepared by James Stanley

And for traders that don’t want to take short Euro positions ahead of the ECB tomorrow, or for those that want to trade against the expectation for more QE out of Europe, or even for those that want to hedge off Euro risk to instead focus on raw volatility with a market-neutral-like approach, similar to a ‘strangle’ or a ‘straddle’ in options markets; traders can look to EUR/JPY to offset that risk.

EUR/JPY has been on a brisk down-trend and has been fighting support in the 121.94-123.07 region for two weeks now. Traders can potentially look at a reversal setup here, and if the ECB doesn’t deliver, this could put in an aggressive pop to the upside.