Is the Euro Signaling Trouble Ahead for US Indices?

As we stated in our latest commentary, Market Analysis, Insights and Perspectives, published on November 14, 2022, US indices have been on an "absolute tear" after falling into a bear market, recovering from September and October lows, and rallying at levels not seen in over 46 years.

A number of market participants — ourselves included — did not expect significant selling into the Thanksgiving holiday weekend, as prices of the Dow Jones Industrial Average (DJI) approached and began testing its medium-term high of $34,255. Its price eclipsed this potentially signficant resistance level by 0.37% — one trading day before closing down 1.45%. What could have been a case of simple "profit taking," the fall in equities prices was attributed to the growing social unrest throughout China over its "zero-Covid" policy.

"An apparent easing earlier this month had fueled hopes of a gradual easing of the country’s strict Covid controls. However, local lockdowns in recent days have seen fears resurface over both the domestic economic recovery and global supply chains."

In juxtaposition with our November 14 analysis, we were already anticipating and forecasting the probability the market might be entering its next phase down — especially if market conditions persevered. The catalyst to further downside — besides market technicals — appeared to be taking shape. 

From a purely technical perspective, a leading indicator signaling what could be the beginning of intensifying selloffs was just triggered in the DJI, its 3x inverse price-weighted average ETF (SDOW), and euro-US dollar currency pairs (EURUSD, USDEUR). 

Narrowing in on the MACD (1-day) of the DJI, it has just crossed below its signal line nearly 800 points above its base line value (0.00) at the critical 34,255 test / resistance level. If momentum in the MACD continues its descent uninterrupted, downside risk could be significant, where we can ultimately fall as far as the October 13 low of 28,664 — or even break below and test the 0.5 Fibonacci level at 27,561. Falling to such levels, however, would only occur under more extreme market conditions. 

The same formation in momentum was just confirmed, but in the opposite direction, in the DJI 3x inverse ETF —  SDOW.

Additional evidence that equities markets have likely struck upwards resistance can be found by examining foreign exchange (forex) currency pairs.

Since record-high inflation and rising interest rates began weighing on the strength of financial markets and the economy, the relationship between equities and currencies prices has become quite telling. Although a perfect corollary between the EURUSD / USDEUR and US indices doesn't exist, rises in the foreign exchange rate have become more positively correlated with US equities prices. The US dollar, on the other hand, has become more inversely related with US equities prices. That is to say, when the stock market rallies, the euro rallies; when the stock market falls, the US dollar soars.

"The [US] dollar is the most commonly held denomination among external bank assets, which include loans to nonresidents and foreign-currency denominated securities, with a balance of around $16.7 trillion, up from a post-global-financial-crisis low of around $9 trillion. Global banks’ US dollar-denominated liabilities have been steadily increasing since the GFC and are the highest among major international currencies, with a balance of over $15 trillion in 2021. The only other currency with a notable amount is the euro, at over $9 trillion of foreign-denominated bank liabilities. The share of US-dollar-denominated external claims funded by FX swaps and forward instruments has significantly increased since the GFC to almost $1.4 trillion in 2021, surpassing that of euro-denominated claims in late 2016. Approximately two-thirds of all dollars in circulation are held abroad, illustrating its continued global appeal as a safe asset."

Just as we're beginning to see a potential shift in momentum in the DJI, the EURUSD is showing an eerily similar underlying technical formation. As we can see, its MACD (1-day) has just crossed below its signal line, as well. Its price — along with all major US indices, excluding the Nasdaq Composite Average (NDQ) — recently tested its 200-day moving average (dma). If EURUSD can't find support at its 200dma and the underlying pattern in its MACD plays out in full, we should expect selling in both the euro and US equities.

While the shorter term rally of the EURUSD has been impressive, its performance remains overshadowed by the resilience and relative strength of the US dollar. With its price currently consolidating at its 200dma and previous longer term peak from January 2, 2017 of 0.9651, USDEUR has formed the same technical pattern as SDOW and other inverse indexes. Finding a longer term top here is as difficult as finding the bottom to EURUSD.  It's not outside the realm of possibility that both the US dollar and euro retrace to their 2000 highs and lows, respectively. If either of these moves occur, downside in equities markets would be catastrophic.