An interesting day yesterday, with interest rate decisions in both the UK and Europe dominating forex markets, coupled with the recent bond auctions in Portugal and Spain which passed off without any major panic. However, it was Europe that took centre stage, not because of any change in interest rates, but in the accompanying statement from ECB governor Jean Claude Trichet, who surprised the markets with his hawkish comments on inflation, suggesting that the ECB would be monitoring this issue very closely and that it would not hesitate to raise rates sooner rather than later, should the need arise.

This prompted a surge in the euro, which gained over 300 pips on the day against the dollar, and ending with a wide side spread up candle on the daily chart, closing at 1.3351 making it four straight gains in a row for the EUR/USD, shaking many short traders out of the market as they run to cover their positions. So, as a euro bear at the moment, what are we to make of yesterday’s reaction, and is this short term bullish momentum likely to continue in the longer term, and to do this we need to consider the daily chart for the EUR/USD along with that of the USD index, as well a look at market reaction to the news elsewhere.

Starting with the reaction itself, the news was hardly surprising, as the Eurozone has weathered the recent economic storm better than most, with Germany leading the economic recovery, and around the world the number one priority has been the focus on inflation as economies begin to emerge from the long deep┬árecession┬áso hardly ‘news’. Secondly, equity markets, a barometer of risk and ones that generally rise as the euro strengthens, remained relatively flat, and indeed both the FTSE 100 and the DOW 30 closed lower last night, clearly signalling that the reaction yesterday was overdone, and certainly not in line with the substance of the comments from Trichet. Finally, the ongoing sovereign debt issues are still there, and nothing much has changed from the start of the week. So what are we to make of this sharp rise and apparent sudden love of the euro?

The answer I’m afraid is rather simple – the forex market makers have seen this as an opportunity to shake the euro bears out of their positions, marking the euro higher on the news and taking the EUR/USD back to the previous high of the last few weeks at 1.3498, where no doubt many short traders had placed their stops. So put simply, yesterday was a stop hunting exercise and therefore one to be ignored, as this was clearly a trap up move in the market. This has been further confirmed in early trading this morning with the pair hitting a high of 1.3457 before pulling back to trade at 1.3378 at the time of writing, with the market makers taking out further stops as a result. Should this hold in forex trading later today, then this will give us an excellent signal of a shooting star candle and a solid position to enter the market once again with further short positions, on the prospect of a longer term fall and a break back below the 200 day moving average once again at 1.3066 in due course. Finally the pullback this morning aligns with the current price resistance at this level, adding further weight to our analysis.

Turning to the USD index, this analysis is mirrored in the daily chart, as the index appears to be finding support at the 78.77 level, where we saw a previous bounce earlier in the month, as well as in mid December 2010. In both cases the index rallied higher from this level, and should we see a close with a hammer candle later today, then expect to see the index rally next week with a consequent fall in the EUR/USD as a result.

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