The euro continued to rally in today’s trading and is beginning to approach key technical resistance around the US$1.2750/EUR area. Though on the daily chart the unit is beginning to look increasingly overbought, the technical pattern points towards further upside for the euro, and I would not rule out a push to US$1.30/EUR.

Exchange Rate - US$/EUR & RSI (bottom)

So how is it that with all the ongoing concerns about Europe’s sovereign credit worthiness, worrying signals in global fixed income markets, and the prospect for a painful internal devaluation of the least competitive eurozone economies (namely the PIIGS), the currency is now rallying? Well, before answering this question, I suggest we identify what has been driving this recent bounce of the euro, which up until early June still looked like it would hit US$1.16/EUR!

• Firstly, let’s remember that speculative short positions on the euro went through the roof in Q1-Q2, hitting a record over 160,000 contracts at one point in mid-May, shortly before the euro hit its recent trough.

• Daily momentum indicators, such as the relative strength index (RSI) began to head into record oversold territory (see chart above) during this period, signalling to investors that the currency may be due for a bounce soon.

Euro FX Non-Commerical Contracts/Futures Only

And bounce it did!

Let’s also remember the host of poor poor economic data coming out of the US at the end of June, ranging from shocking new home sales numbers – now that government stimuli are being withdrawn – to a very bad outlook for the US labour market. This hardly augurs well for the US dollar, and has therefore seen the greenback begin to slide. So, combine technical unwinds of euro shorts, catalysed by bad US fundamentals and you have a recipe for a big correction.

Does this mean that the euro’s troubles are now a thing of the past? Certainly not, if you ask this dog! Ask most analysts out there and they will tell you that Greece is still set to default (or restructure as some prefer to call it), and Spain’s housing bubble is increasingly becoming ripe for a major correction.

I would therefore caution against premature optimism, and note that my colleagues at BMI are still wary of the potential negative impact another sell-off in the euro could have on some of the more favoured European currencies, such as the Polish zloty and Turkish lira. So while the euro may have further to go for the time being, the fundamental picture for the eurozone remains a poor one. We believe that beyond an unwinding of speculative short positions in recent weeks, all that has happened is that the easily bored financial investor has shifted his/her attention to economic events in the US. That’s all.