Someone asked me why the EUR/USD took a 200 pip drop during the New York Session.
Here are some of my thoughts on the situation.
The sizable risk aversion in the marketplace did not occur until around 7 AM EST. Then eventually stocks started dropping more quickly than before.
There were rumours that the French credit rating could be downgraded. The rumours may be unfounded, but it could be enough to make Euro longs dump their positions. Eventually some people may say, if the U.S. got their credit rating cut, perhaps French finances aren’t in the best of shape either? And France is the second largest economy in the eurozone so that is a big concern. Not that they will default, but that the risk goes higher and it makes it more difficult to help out the other eurozone nations and fulfill the current support obligations.
That caused some resurgent sovereign debt concerns.
There were also some Italian and French banks whose stocks got hit extremely hard. Some of them dropped 10% of more in one day. And when you see a bank stock drop that much in Europe it is usually from worry over sovereign debt exposure. A 10% drop in the current market environment is not because of lower growth projections in the future. It is because of fear of losses in the European banks and their exposure to sovereign debt.
Also some trading in shares of the banks were suspended. Some traders were trapped in their positions. And when traders are trapped in their positions they start looking for a way to hedge. If you are stuck long some European Bank and you cannot dump your position how do you hedge it?
You short EUR/USD. So some traders may have decided to short EUR/USD to hedge their exposure to some European banks.
Also, if any traders are looking to initiate any fresh bets on the sovereign debt crisis expanding, it may be difficult for the traders and market participants to short the bank stocks when they have already gone down 5-20% already. They may not feel comfortable shorting at those fresh lows. Therefore, some of them take the position of shorting the EUR/USD instead. From a relative value point of view they may think it is a good bargain to short it. Bank stocks have gotten hit, the AUD/USD is already down 1,000 pips, but the EUR/USD is still stuck in a tight trading range. So they may be thinking that it is a bargain to short it. They figure the reward risk is more attractive shorting EUR/USD than some other trade. They can rationalize it by saying if EUR/USD does breakout to the downside that it will be for a big move say 1,000 pips or so. They are running reward risk ratio potential calculations and can decide that shorting EUR/USD is a decent play. At least that is their calculation and perception of the situation. They can be wrong.
You may say why don’t they short EUR/CHF? They can do that, but EUR/CHF has fallen so much, they may feel uncomfortable to short it at the lows. Also the small potential for intervention exists in EUR/CHF to push the prices higher. Intervention risk to push EUR/USD higher is zero right now. Although of course other risks remain to push EUR/USD higher.
That is part of my rationalization for the reason why price moved. Some people may consider it too “airy fairy” but I would much rather rational price movement by the above rather than attempt to describe it using moving averages, divergence, forex robots, etc.