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Foreign Exchange

Options hedging points to further euro losses

EURUSD moved down towards $1.30, as stumbling blocks to the EU’s fiscal compact emerged, while traders warned that option hedging was likely to exacerbate the move lower in the single currency

Headlines • Franco-German hopes for a swift, new treaty under threat as non-eurozone EU states warn they might struggle to push the legislation through their national parliaments – FT

• Italy pays a record 6.47% per cent for five-year bonds, up from 6.29% last month, and issues €3bn in total

• Merkel rules out raising the upper limit to ESM funding above €500 billion

• FOMC keeps policy unchanged; says US economy expanding moderately

• Chinese leaders pledged “stable and balanced growth” while fighting inflation

• BoE’s Dale says inflation will fall sharply during next three months

• RBA’s Battellino says it is inevitable Australia will suffer spillovers of the eurozone downturn

Market reaction

EURUSD’s downward momentum accelerated after breaking below a key support level, which traders said opened the door for further weakness.

The move down towards $1.30 has been largely driven by option barrier and stop-loss-related selling, exacerbated by thinning market liquidity after the October low of $1.3146 was breached on Tuesday. Many are now targeting the low for the year at $1.2859.

Pressure on the single currency has intensified amid fears that last week’s EU summit and proposed fiscal changes would do little to alleviate the eurozone sovereign debt crisis.

Helping the euro lower on Wednesday were reports that four EU governments said legal constraints might prevent them from signing up to proposed treaty changes, which threatened a drawn-out process for fiscal consolidation in the region.

News that Italy paid a record yield in a five-year bond auction also did little to help the single currency’s cause.

Meanwhile, the euro also came under pressure against the pound, with EURGBP hitting its lowest level since February. EURCHF also dropped towards SFr1.2320, although traders remained cautious ahead of Thursday’s Swiss National Bank meeting, at which some believed the central bank would raise the floor in EURCHF from the current SFr1.20 level.

Elsewhere, heightened investor risk aversion weighed on commodity-linked currencies, while the dollar and yen found support.


Persistent selling from real money and leveraged players stemmed EURUSD rallies up to $1.3050 and kept EUR crosses under pressure. Talk suggested that a break below $1.30 would trigger options barriers and accelerate the downside move in spot, as option players covered lost gamma.

“We remain core short EURJPY and have added EURUSD,” says one spot trader at a leading bank. “At these levels we are looking for the yearly lows and will re-evaluate above $1.3185.”

EURGBP is testing £0.8400 after selling from European fund names. The presence of several stops and negative gamma below this level is likely to accelerate any move below £0.84 down towards £0.8300.

AUDUSD came back from overnight lows just below parity, as Asian-based buying fuelled a rally up to $1.0031. This has proved a firm resistance level in the short run as intra-day players have been sellers at the $1.0030 mark.

Meanwhile, EURJPY has been a key cross that has come under pressure, falling to less than one yen above the 10-year lows reached two months ago. Tokyo-based strategists at Citi have pointed out that Japanese exporters have budgeted for a EURJPY rate between ¥105 and ¥110, and so are underhedged if these levels persist. Moves down towards ¥100 could be fuelled if exporters cover underhedged positions.

Interest in USDJPY is still low. Order books at top banks show very little interest, with offers above ¥78.50 and bids down to ¥77.60.


Extreme funding strains continued in the swaps market, despite the recent announcement from the Federal Reserve and other global central banks to lower the cost of their dollar swap facilities.

The premium paid for dollar funding has risen sharply since the start of the week and the intensification of the slide in EURUSD.

The benchmark EURUSD three-month cross-currency basis swap, which last Thursday was standing at -116 basis points, widened out to -155bp at one point on Wednesday. That is not far from the post-Lehman record of -162bp it hit before global central banks moved to inject dollar liquidity into the market.


The options market might have been complacent in appropriately pricing in EURUSD move to 11-month lows, said options strategists at a top European bank.

 EURUSD 1m implied vol vs spot
 Source: Societe Generale

While implied volatility has been on the rise, this is less than could have been expected given the recent spot/vol relationship and the current level of risk reversals. EURUSD one-month implied volatility is trading at 15.2. The last time vols reached this level was when spot was at $1.35 – and when EURUSD last dipped below $1.32 in October, vols were up above 17.

On Monday, three-month implied volatility and risk reversals were 15.3 and -3.6 respectively. At these levels, a move down to 1.30 would drive the three-month vol to 15.95, while it has been trading at 15.65 in the market so far.

What to look for

“Despite the risk of further weakness in the global growth outlook, on the basis that China is able to avoid a hard landing, short EURAUD could be worth a bet at these levels,” says Stephen Gallo at SchneiderFX.

Later in 2012, persistent strains in the eurozone could also add further weight on EURAUD, as reserve flows continue to keep their distance from both USD and EUR.

As such, commodity-linked AAA-rated currencies, such as AUD and CAD, might not fall as much as some expect due to demand for safe homes for FX reserves.

“The bottom line is that we may finally be ripe for levels between A$1.2750 and A$1.29 in the pair,” says Gallo.

Spot, 6.45, EST

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