The short-term and long-term patterns on display in the EUR/USD epitomize the conflict in the currency market. The short-term bull flag portends further upside, while the long-term head-and-shoulders top suggests downside. The conclusion of one, or both, of these patterns will likely dictate the next cyclical move in the EUR/USD and, indeed, the direction of the U.S. dollar in general.
The EUR/USD is the most actively traded and closely watched pair in the currency market. Consequently, the EUR/USD is an excellent proxy for the U.S. dollar in general.
The EUR/USD is in the midst of a head-and-shoulders top, which began forming in 2003. A head-and-shoulders top is a bearish reversal pattern. The head of the pattern marks the EUR/USD's all-time high near 1.3600, while the two shoulders fall into place at 1.2950. The right shoulder marks the EUR/USD's short-term high.
Source: Prophet.net
While the head-and-shoulders pattern has been forming, the fundamental backdrop of the EUR/USD has been going through dramatic changes. Foremost of these changes has been the widening interest rate differential, in favor of the U.S. dollar. The Federal Open Market Committee (FOMC) has taken short-term interest rates in the United States to 5.25 percent, which is 250 basis points better than the equivalent European Central Bank (ECB) rate of 2.75 percent. The FOMC has been far more aggressive in raising rates than the ECB over the past three years.
But with the FOMC recently signaling a pause in rate hikes, and the ECB turning more hawkish, the interest rate differential between the euro and dollar may start to narrow, which is negative for the greenback.
The short-term view of the EUR/USD, in contrast to the long-term view, supports a bullish outlook for the euro and bearish outlook for the U.S. dollar. In other words, the EUR/USD's short-term pattern points higher. The pair is consolidating within a bull flag, which is a continuation pattern. These patterns typically break in the direction of the prevailing trend, which in this case is upward.
Source: Prophet.net
Note that the short-term high of the bull flag of 1.2950 is the right shoulder on the longer-term chart.
The confluence of patterns over different timeframes sets up two 'if-then' scenarios for trading the EUR/USD. If the EUR/USD breaks its short-term bull flag, and then violates the head-and-shoulders with an advance past 1.2950, then the pair most likely goes on to retest its all-time high. Alternatively, if the EUR/USD breaks down from its bull flag, then it will probably trend towards the neckline of the head-and-shoulders at 1.1700. Either outcome represents a big move in the pair, which makes both of the patterns worth monitoring for the remainder of the summer.
The fundamental impetus for a break of either pattern will most likely come in the form of interest rates. The ECB might start hiking rates more aggressively, which is reason for the EUR/USD to violate its head-and-shoulders and then trend higher. Or the FOMC might continue hiking rates more than the market is currently expecting, which is supportive of the head-and-shoulders.
Whatever the outcome, a big move is forthcoming. Follow these two patterns in the EUR/USD to discern the direction of the next big trend in the currency market.
Eric Utley is a full-time trader with over a decade of experience in equities, equity options, futures, and currencies. He specializes in trading currencies, using a combination of quantitative, technical, and fundamental analysis. He is the lead contributor to INVESToolsCT.com, produces educational programs, and hosts a weekly online seminar.
