By Evaldo Albuquerque, Editor, Exotic FX Alert and Currency Capitalist
Europe’s woes will not be banished – and this week, just when you thought it was safe, things got even worse.
Spain announced its 2011 deficit will be much deeper than anyone thought – and that means it will almost certainly need a bailout, sooner or later.
Borrowing costs for countries like Italy and Spain are still skyrocketing, which makes it harder for them to roll over their debt.
Meanwhile, trading in UniCredit, Italy’s largest bank, was suspended after shares tumbled in response to a heavily-discounted share offering. This indicates the bank is having trouble raising capital, making it a strong candidate for another European bank failure.
How Low Can it Go?
There’s no question that all this is bad for the euro.
But how low can it go?
We don’t have a crystal ball, but we have the next best thing – chart patterns.
One of the most reliable chart patterns, known as Head & Shoulders, is now saying the euro could drop all the way to $0.90.
If you’re not familiar with this pattern, you can read this article I wrote last year explaining how it works.
In that article, I also showed how this pattern could have saved your portfolio from the 2008 stock market crash.
It’s basically a pattern that indicates that an asset will move lower, much lower.
Let’s take a look at the big picture for the euro. Below is a monthly chart that goes back to 2001, when the euro started a major bull market. Notice there’s a massive potential Head & Shoulders forming right now.
I say “potential” because this pattern is only complete if the price closes below the black line, known as neckline.
Right now, that line is at 1.24, so the euro is still trading above it – but not by much. It’s trading around 1.27 today.
One of the great things about this pattern is that once it’s complete the price usually falls by the same distance that separates the top of the head and the neckline. So you can use that distance to project a minimum target.
The target in this case would be around $0.90, which is much lower than anyone expects the euro to go.
But can the euro really close below 1.24?
Well, another Head & Shoulders pattern, this time on the weekly chart going back to 2010, shows it will certainly happen.
Notice that the price has already closed below the neckline. Using the distance between the top of the head and the neckline, you get a minimum price target of 1.22.
The Fed Will Keep the Dollar Weak
My observation about the Head & Shoulders is not a prediction. It’s just, well, an observation.
I rarely disagree with the pattern because it’s very reliable. But I find it hard to believe the euro will move all the way to $0.90. Why? Because of the Fed.
If the euro drops that much, it will mean the dollar will be much stronger – and the Fed won’t allow that to happen.
It wants a weak dollar to boost the U.S. economy through exports.
Besides, if the euro drops much lower, Europe will very likely be in a very deep recession.
The euro zone accounts for about 16% of the world economy. If we get a deep recession over there, it’s unlikely the U.S. will be immune.
If a recession spreads from Europe to the U.S., the Fed will have a good excuse to start printing money again, driving the dollar lower.
Nonetheless, the Head & Shoulders pattern indicates the major trend of the euro remains down, and it could move all the way to 1.22 in the weeks ahead.
Profiting from the Smaller Currencies
And if it closes below 1.24 on the monthly chart, we will have strong evidence the euro zone is falling apart, and the euro will move much lower.
It also shows that, if the euro fails to close below 1.24 on a monthly chart, it could have a big rally, much like it did in 2009 and 2010.
There will be a lot of demand for the euro around 1.22-1.24. So my instinct is that will be a great level to buy the euro for a short-term trade.
But for now, any euro rally is a shorting opportunity. I will be betting against the euro by shorting smaller European currencies, such as the Czech koruna and the Polish Zloty.
Very few people believe the euro will move all the way to parity. I don’t know anyone who believes the euro will move below it.
But the Head & Shoulders says the euro’s downside risk is much larger than anyone thinks, and it could still move all the way to $0.90.
Editor, Exotic FX Alert and Currency Capitalist