Between EUR USD 038 USD Index

This week may have seen “light” news flow from Europe but it did not prevent a 1.4% loss in EUR/USD in the last four days so far, hitting fresh two-week lows. The core of the losses over the past 24-hours has been attributed to something we long warned about – The realization that Operation Twist from the Fed will not be sufficient in overturning negative market eroding sentiment suffering from the negative macro figures, without the coordinated help of liquidity operations from the ECB and Japan.

Three weeks ago, we anticipated EUR/USD to deliver a few more false rebounds before charting a gradual descent on its sub-1.20 path. The pair retested the $1.27 figure only once since its close below $1.25 in late May. Now that EUR/USD has hit fresh two-year lows at $1.2167 and the US dollar index hit new two-year highs at 83.61, the broadening case for a higher greenback is more apparent.

We already highlighted the technical case for further run-ups in the USDX on here.

As the central banks of the once-powerful commodity currencies are forced to adopt more accommodative policies, the downside in their own currencies grows more ample. This would force traders to diversify their USD longs away from EUR-pairs and onto a classic deleveraging play against commodity currencies. The Bank of Canada has already issued more dovish comments, but has yet to mention rate hikes in its policy reports.

And since CAD is included in the six-currency index of the US dollar index, making up 4% of the basket vs. 57% for EUR/USD, the next leg of declines in the loonie resulting from more BoC dovishness is likely to trigger more amplified moves in the USD basket. Thus, with $1.2050 seen as the next viable stop in EUR/USD and USD/CAD likely to retest 1.0320, USDX U-turn should likely continue, with 85.00 standing as the next key resistance, 76% retracement of the decline from the June 2010 high to the May 2011 low.