The dollar takes a breather

The euro is getting some bad press lately with the confession the IMF admits it has made a few boo-boos regarding its euro policy and its failed policy towards Greece.  Basically, the euro fanatics inside the IMF concocted a dodgy dossier that hoodwinked the board (sound familiar, Tony?), including Lagarde, to implement a disastrous austerity regime on Greece – all in order to ‘save’ the euro.

To me, this is a great example of group-think where an ideology takes hold among a few of like mind – and grows like Topsy as many new adherents see its advantages;  usually pecuniary in nature, or even power-attracting.

But the policy was flawed from the start as its effects became obvious – even to many of the fanatics.  Of course, this outcome was entirely foreseeable from the start to more level-headed minds.  The Greek economy has been a basket case for years and shows little sign of repairing itself with stubbornly high unemployment and citizens living hand-to-mouth off subsidies.

The phenomenon of group-think is rife in financial market, of course.  It is something I study avidly and incorporate in my market analysis.  It is often called ‘herding’ where a theme (usually a simple idea) takes hold and spreads rapidly.

For swing traders, it is important to know that hedge funds are especially prone to herding because the majority are trend-followers (momentum players), not reversal-pickers.  They like nothing more than to see a trend develop and then jump on board.  Of course, much of the trend may have played out by that time.

When they spot a trend developing, it can be easily explained and a trade justified by  quoting that simple theme and as the trend moves on, more and more traders are drawn to the conclusion that the basic idea is correct and jump on board to perpetuate the trend.

And when enough converts have been made, the market ‘suddenly’ reverses to trap the late-comers.  It is a beautiful thing to behold when you understand the dynamics.

This scenario is currently being played out in EUR/USD.  Here is the long term weekly chart

It is important to realise that the euro is trading at precisely the same level as it was 18 months ago – and much ink has been spilled in the meantime forecasting its demise! In fact, the whole pattern is that of a wedge – one of my favourite chart formations.

In a genuine wedge, I like to see five waves labeled A,B,C,D and E.  I believe last week saw the low of wave D and we are rising up in the final E wave before an almighty crash down towards parity.

But the interesting point here is that last week’s D wave low was put in as hedge funds ramped up their bearish bets, thereby following their age-old custom of being on the wrong side of the market just as it turns.  Here is the latest COT data as of last Tuesday as the D wave was making its low

Going into last week, hedgies (non-commercials) were already massively bearish by well over two-to-one as they followed the downtrend off the May 1.16 high by adding to short bets.  But at Tuesday’s low at 1.10, they had added even more bearish bets in the previous week with a new swing of 13k contracts.

Here is the daily chart

And they were rewarded by a jump of two cents to yesterday’s close.  That is group-think in action.

I am working a blue tramline pair that I have had in place for some time and I expect them to remain as lines of support and resistance (until proven otherwise).

So as the late-coming shorts realise they have bet the wrong way, they will be covering their shorts and helping to propel the market up.  My first target is a kiss on the underside of the blue tramline in the 1.13 area.

Did I have any more evidence for a EUR/USD turn?

I certainly did!  Although the euro makes up a big chunk of the dollar index, they do not always move in opposing lock-step.  That is why I am always on the lookout for any diverging behaviour – and found some last week.

I had been long the dollar but became increasingly nervous early last week as I noted a large potential momentum divergence on the daily – and the market has moved into solid resistance provided by the Fibonacci 62% level and also chart resistance.

Remember, the 62% retrace is the most common point for a turn or at least a major pause in the trend.  But with the A-B-C look to the rally off the May low and the momentum divergence as added negatives, I took major profits on long dollar trades near last week’s highs.