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Euro feels the heat as Rome burns


The Italian Job:  bond woes fuel eurozone breakup fears

The euro suffered as a meltdown in the Italian government bond market raised fears over a break-up of the single currency. The week started with EURUSD finding support, hitting a high of $1.3859 after Italian prime minister Silvio Berlusconi pledged to step down from office, news that some took as a sign that Italy might be given some breathing space to get its finances in order.

However, the rally in EURUSD was short-lived, as a decision on Wednesday by LCH.Clearnet, Europe’s largest clearing house, to raise the margin required to trade Italian government bonds sparked a wave of position liquidation in the securities.

The move took the yields on benchmark 10-year Italian bonds to a euro-era high of 7.43% and drove EURUSD sharply lower as investors questioned the ability of Rome to finance its massive $2 trillion of long-term debt, and fund selling triggered a series of stop losses.

Italian yields hit levels that previously triggered bailouts for Greece, Portugal and Ireland, but the problem was that no facility has been put in place by eurozone authorities to rescue a country of the size of Italy.

EURUSD plunged to a low of $1.3484 on Wednesday, with speculation rising that Germany and France might call for a redesign of the eurozone to include just its strongest member states.

ECB: The reluctant hero


The drop in Italian bonds put pressure on the European Central Bank to step into the market and buy Italian debt, putting to the test its determination not to become the lender of last resort to debt-stricken eurozone nations. In the event, reports of aggressive buying of Italian debt from the ECB, which pushed yields back down below 7%, and news that Rome had managed to sell €5 billion of one-year bills, all be it at elevated yields, helped to stabilise the euro on Thursday.

Also helping sentiment in the euro was the prospect of new technocrat governments in Italy, with former EU commissioner Mario Monti expected to be installed as prime minister in a national unity government.

The potential for the removal of political uncertainty raised hopes that Italy would get to grips with financial reform and pass austerity measures though the Senate and helped drag EURUSD back to $1.3650 on Friday.

Euro resilience unlikely to last

Chris Turner, head of foreign exchange strategy at ING, said Italy looked “too big to fail and too big save”, adding that the threat of France and Germany formally recognising EMU exit as a policy option demanded a much larger risk premium of the euro.

He said the divisions within the eurozone were being exposed at a time of sharply weaker growth in the region, with bank deleveraging and the ensuing credit crunch potentially sending it into recession next year and ECB interest rates to 0.75%.

“EURUSD looks set to trade to $1.30, with risk to $1.20,” says Turner. “Most eurozone policy options, be it massive ECB buying of peripheral debt, or aggressive easing of policy, look euro negative.”

Swiss franc: SNB holds off further action for now

SNB governing board

The Swiss franc returned to the spotlight as the threat of deflation resurfaced and a series of comments from Swiss National Bank board members prompted speculation that the floor in EURCHF might be raised from its CHF1.20 level. SNB top brass Philipp Hildebrand, Thomas Jordan and Jean-Pierre Danthine continued to express concerns that the franc at current levels “remains very strongly overvalued” and said the SNB was ready to take “further measures if the economic outlook and the deflationary development make it necessary”.

Monday saw the release of the Swiss consumer price index, which dropped 0.1% in October, taking the annual rate of CPI into negative territory for the first time since late 2009.

As a result, EURCHF climbed as high as CHF1.2456 on Tuesday as investors priced in the prospect for a higher floor.

However, as policymakers failed to act on the recent rhetoric, EURCHF reversed gains, slipping back to a 1.23 handle before moving back up to 1.2350 on the back of a modest euro recovery.

Looking ahead, November consumer and producer price indexes will be important indicators to determine how much deflation continues to threaten the Swiss economy.

“Our view is that there is a strong chance they will raise the floor but we might need to wait for more data,” says Geoff Yu, FX strategist at UBS.

“If there is a negative print in price indexes, then there is a very high likelihood we will see the SNB increase the floor and we would expect prior conditioning in the market beforehand.”

Japanese yen: USDJPY grinds lower despite ‘stealth’ intervention

There had been little movement in the Japanese yen after the BoJ’s intervention last week, with USDJPY meeting firm support at the 78.00 level.

Reports soon circulated that the BoJ deposits data indicated the bank continued to intervene covertly, subsequent to the initial bout of yen selling on the October 31, estimated to be in the region of Y8 trillion.

But as Italian bond yields rose above 7% to euro-era highs, the yen began to resume gains. EURJPY fell back to 105 as investors abandoned the euro and USDJPY crept lower towards 77.00 as safe haven flows returned to the yen.

“Given domestic and exporter demand for the yen, as well as its safe haven status, we do not think intervention will have a lasting effect and remain bullish JPY,” says Dara Blume, FX strategist at Morgan Stanley.

Options: Funds hedge against euro death

The most significant development has been the re-entry of non-traditional FX participants into the option markets, in reaction to the surge in Italian bond yields and the impending vote on austerity measures.

That saw buyers of what was typically short-dated low delta downside protection, in what traders describe as “decent size” across the market. One trader says that much of this interest comes from equity funds putting on tail hedges, as a hedge against the break-up of the euro in the coming weeks.

“This is more of a hedge for, if it is a view, it seems that this type of interest sometimes comes at the end of a cycle,” a trader tells euromoneyfxnews. “I don't quite believe we are there just yet, for our sense right now is that we are in the calm before the storm, rather than ready to breathe a sigh of relief.“

Another trader, at a top-three options bank, says this short-dated interest contrasts with the recent activity seen from the macro hedge fund sector, which has typically shown interest beyond the six-month tenor.

However, as the week draws to a close, implied vols were drifting off, leading another trader to surmise that downside hedging is not of sufficient size to keep vols elevated. Nevertheless, any further softening of vols should be a buying opportunity, with dips becoming shallower.

As of Friday, EURUSD one-week vols were trading at 15.75, 1.65 vols lower than the weekly high reached the previous day. One-month vols also drifted off 0.75 vols from a weekly high of 16.4. Risk reversals are also 0.1-0.2 lower across the curve (1m25d RR has fallen from 4.1 to 3.9), according to Citi.

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