by Frank Pavilonis

The Euro has seen a recent bounce, along with the U.S. stock market. However, I think the euro rally will fade given the still-shaky economic situation in the Eurozone. Overall, I think the trend is still bearish, but right now we are seeing a bit of a short squeeze.

The debt crisis in the Eurozone had pushed the euro down to a four-year low versus the U.S. dollar, and although the September futures could correct up to $1.2450 – $1.25, I think savvy traders will use bounces as selling opportunities. On Monday, Moody’s Investor service cut Greece’s credit rating to non- investment grade, or junk (Bb1). This could lead to downgrades of German and French banks, which had lent roughly $1 trillion to Greece, Spain, Portugal and Ireland by the end of 2009. In addition, three-year credit default swaps on Spanish debt are at all-time highs.

Participants in the futures market remain bearish. The Commodity Futures Trading Commission’s most recent Commitment of Traders report revealed that speculative short positions in the euro reached the second highest reading in a year. Speculative bets against the euro hit an all-time high of $18 billion on May 11, 2010.

I feel the equity markets will be quite volatile this week due to option expiration, but technicals look bullish for now, and Federal Reserve policymakers have been trying to talk up stocks.  Strong economic reports from China also helped create a short-term bottom and fueled the return of the “risk trade” in the markets, bringing momentum back into stocks.

Looking at a chart of the euro, I a bullish divergence reflected in the Moving Average Convergence Divergence (MACD) and the Relative Strength Index (RSI). I think with option expiration this week, it’s perhaps too early to short the market. I see $1.2450 – $1.25 as the next level of resistance that will create a good shorting opportunity for bearish traders. I don’t feel the trouble with the euro is over yet.

S&P 500

The S&P 500 futures chart also shows a bullish divergence, and although 1,100 could be the line in the sand for the September futures contract, I think the market could extend a rally to at least 1,106 – 1,109 and close a chart gap near that area. Longer-term, I think 1,140 looks like a good upside target. This week’s action could sucker some players in to get short, but I don’t see the likelihood of a crash if everyone is expecting it.

The stock market and the euro have seen a fairly strong correlation over the past few months—as trouble in the Eurozone has caused concern about the global economy at large, and driven investors out of risky assets. I recommend traders watch the euro/yen cross as a way to gage how investors view risk as well, as the yen has also traditionally played the role of a safe-haven currency. The euro/yen has been a tremendous indicator in terms of determining whether the correlation between the S&P 500 and euro is simply a fake-out, and/or is likely to change.

Feel free to contact me with any questions you have about the markets, and to develop a customized trading strategy based on your unique goals and risk tolerance.

Frank Pavilonis is a Senior Market Strategist with Lind-Waldock. He can be reached at 866-631-6216 or via email at fpavilonis@lind-waldock.com.

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