Originally published by AxiTrader
Correlation and causality.
That's the thing they teach you in Stats 101 when you get introduced to the dark art of statistics. And I say dark arts because with a little creativity you are a good chance to find a correlation between many things which have no business being seen as related.
And as a result, you can plot two items on a graph and show that they are highly correlated.
I've written all of that because in the reach for an explanation as to why the obvious benefits of a strong economy, a Fed raising interest rates, and a US dollar falling there have been plenty of relationships touted as helping to explain it.
One of them was the rate of a 2-year EU govie forward 2-years.
At first, I called BS on that one. But when I thought about it, even though it was clear this was not a strong long-term driver of the EUR/USD and even though I know that any exchange rate is not the product of a single factor model, I had to think about the rationale as to why traders might be using it as a proxy.
So I sat down and tried to work out the old correlation and causality link.
What I came up with was that in a world of synchronised growth - where the US was strong but EU growth had to be repriced upward - traders knew the time had come for the ECB to stop buying bonds and to end its QE program. But when would the ECB start raising rates?
Enter the focus on the 2-year forward 2-year Government bond rate as a proxy for where EU rates were headed in the future. It's been a reasonable directional indicator of the euro since late 2016 but nothing like the sort of correlation EUR/USD has had with it since Q4 2017.
But I'm comfortable with two things.
It's not the only input into any model deriving an expected EUR/USD rate (even though it's very strong right now) and it has been where forex traders have looked for guidance on the policy convergence/divergence debate recently.
And on that front with the Citibank Economic Surprise Index for Europe having collapsed to -4 at the moment while the US still sits at 50 it might explain why expectations about where EU rates are headed in the future has also been recalibrated.
So I'm comfortable that the tightening of this relationship since December when the US dollar came under heavy pressure (as seen in the chart below) helps explain why the euro is under pressure.
All the good news was priced in. Data is not weak, but not beating expectations. So interest rate traders are subtly recalibrating their expectations for the ECB and as a result - especially while the Fed remains resolute - the euro is under a little downward pressure.
When I look at the daily chart what becomes clear is that euro has made a double, perhaps triple, top above 1.25. What's also clear is that it is currently resting on the upside of the old up channel. A break of Thursday's low would be a clear sign that euro is heading well back into the channel.
That level is 1.2259 and then there is substantial support at the recent low around 1.22. That level remains the key to a deeper retracement - perhaps even all the way to the other side of the channel which sits around 1.1990 this morning.
Have a great day's trading.