The financial markets continue to reflect the increasing uncertainties related to the Sovereign Debt Crisis in Europe and its ripple effects on the rest of the world. With the precarious nature of the fragile period of stability currently holding the markets together, a brief analysis that captures a worst case scenario and its effect on the currency market would be of tremendous interest to Forex traders.
Many of the major currency pairs that were affected by the safe-haven flows during the 2008 Financial Crisis are now moving within similar Consolidation patterns that preceded the sharp breakouts 4 years ago. However, given the much larger size of these patterns today, a major market event that disrupts the fragile period of stability could lead to even stronger breakouts over a longer time period. This analysis will therefore take a look at the potential short-term and long-term effects on the EURO USD, AUD USD & GBP USD of such an event, using the theories behind Consolidation breakouts as the basis for the price forecasts.
2008 FINANCIAL CRISIS
In 2008, safe-haven flows that sought the preservation of capital through the US Dollar and the Japanese Yen led to large and sharp movements in the values of several of the major currency pairs. While these movements appeared to be unexplainable and unexpected to the untrained eye, there were certain technical setups that were associated with them that reflected normal market patterns. These were the typical Consolidation patterns and Price Channels that are now defining the movements on these currencies, which if traded correctly, can be just as profitable as they were during 2008.
TECHNICAL SETUPS IN 2008
Between January and July of 2008, this pair hovered within a 1000-Pip Pennant before starting to break short at the start of August. The breakout in favour of the US Dollar lasted another 7 months before the currency began to settle down ahead of the renewed risk-appetite in 2009. Overall, the effect was a 6000-Pip drop before the GBP began to recover lost ground.
After moving between Support and Resistance in a large Price Channel between February and July of 2008, the breakout for this currency pair started at the end of July. It only needed 3 months to register a 3000-Pip decline before starting the rally in 2009 in favour of the Aussie. As with the other pairs, the breakout was sharp and fast with only temporary pullbacks before resuming the overall downtrend.
The EURO USD began its own breakout in August 2008 for a 2,200-Pip decline that lasted for 4 months. The start of the decline began with the break of a Range setup that defined the currency for 5 Months earlier that year and following this decline, the currency then rallied on two occasions for a Double Bottom formation that was the precursor to the gains for the Euro in 2009.
The reaction of these currencies to the chaos of the 2008 Financial Crisis reflected the typical behaviour of Consolidation patterns once they are broken. These setups always reflect the indecision of the market in relation to a major underlying economic issue and once there is a major development that confirms the concern of investors, there will usually be a reaction that leads to these aggressive breakouts.
At present, these pairs are once again consolidating, but within larger boundaries of Support and Resistance. This implies an even greater level of uncertainty and trepidation regarding the underlying crisis affecting the movements of these pairs. Since the major factor influencing these currencies stems from the crisis in Europe and to a lesser extent the United States, a major market event from these countries could trigger another period of safe-haven flows towards the US Dollar over a longer period of time.
POSSIBLE CRISIS SCENARIO IN 2012
Let us assume that an unexpected sovereign debt default or a banking crisis in Europe leads to a panic that destabilizes the financial markets in September. The knee-jerk reaction to this event would be to unwind positions in risky assets and channel the funds towards safer assets that would be able to withstand the shocks emanating from the new crisis. As the events unfold, the US Dollar would be high among the list of safe-haven assets, leading to sharp gains in the currency relative its ´riskier` counterparts.
The short-term reaction would be assumed to last for 5 months (average period for these pairs in 2008/2009) similar to the period between 2008 and 2009 before the reversal of the safe-haven flows. However, in the current hypothetical scenario, the currencies would be expected to pullback only briefly before continuing the downtrend for further US Dollar gains, given the larger size of the Consolidations. In this second wave, that would represent the long-term reaction, the currencies would decline to prices that coincide with the ´Breakout Equivalent´ of these Consolidations- the distance equal to the width of the Consolidation at which point all breakouts usually end.
In the short-term, this currency pair would be expected to decline by 2,300 Pips similar to what took place in 2008. This would take it to parity by December this year as it breaks sharply below the Support of the large Monthly Pennant on the Monthly Chart.
After breaking to the 1,0000 psychological Support point, the Euro would rally briefly to potentially test the broken Support area at 1,2300 before U-Turning sharply to resume the downtrend. In this next long-term wave of the breakout, the currency pair would decline by another 2,000 Pips to take it to 0,8000 between 2013 and 2014- the distance equivalent to the width of the broken Pennant.
Relative to the GBP, the USD would rally to a value of 1,4100 below the Support area of 1,5300 on the Monthly Chart within the short-term. This distance would be the Breakout Equivalent of the Weekly Chart´s Range which has been formed just inside the Support of the larger Monthly Pennant.
Over the longer term, the breakout would continue in favour of the USD until parity is reached at 1,0000. This would coincide with the Breakout Equivalent of the width of the Monthly Chart’s Pennant, (though not visible on the chart).
For the Aussie Dollar pair, the short-term reaction would carry it to 0,7500 for a 2,000-Pip decline from the broken Support area of 0,9500. This distance would be the Breakout Equivalent of the Pennant which has been formed over the last year that brought an end to the 3-year rally for the Aussie after the 2008/2009 sell-off.
Given the absence of another technical setup that can be used to forecast the next wave of the breakout beyond 0,7500, the continuation of the trend would depend on the presence of more selling signals in response to the evolution of the crisis. This could carry the currency pair closer to the 2009 levels when the market started rallying in favour of the Aussie.
Consolidations are very important technical patterns that can be used to profit from breakouts during normal periods of volatility as well as during crises. The larger these are, the more significant the underlying factors and the longer the period over which the currencies will trend once the boundaries are broken. The period of safe-haven trading between 2008 and 2009 was a typical example of how breakouts can be anticipated and traded for profits regardless of a trader’s knowledge of the underlying developments leading to the breakouts. Once the patterns are identified and interpreted correctly, large gains are there for the taking for both short-term and long-term traders across the pairs to be affected.