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Foreign Exchange

China saddles up the white charger

A dismal start to trading was suddenly reversed as China rode to the rescue of global markets and moved back into easing mode, pushing the dollar lower across the board

Headlines • The PBOC lowers the reserve requirement ratio for banks by 50 basis points, the first cut in 3 years.

• S&P cuts ratings of BoA, Barclays, Citigroup, Goldman Sachs and JP Morgan, applies “revised” bank criteria to 37 of largest rated banks

• Chief executive of the EFSF, Klaus Regling, says that it will take time to increase the leverage of the fund. He notes: “We don't expect commitments from investors in the next days

• Eurozone finance ministers agree to release 6th tranche of cash to Greece

• German unemployment drops more than expected, down 20,000 to 2.91 million

• Japanese industrial production grew 2.4%mom in October, beating consensus estimates.

• Japan’s MOF sold Y9,029 billion in FX intervention October 28 to November 28

• Swiss KOF leading indicator came in weaker than expected falling to 0.35 in November and was revised down in October.

Market Reaction

China turned currency markets on their head on Tuesday. Asia had traded with a risk-averse tone reflecting S&P’s overnight banking downgrade as well as speculation that Chinese manufacturing PMI, released tomorrow, will come in well below expectations.

The USD gained across the board with EURUSD reaching a low of $1.3259 and AUDUSD falling back below parity to a low of $0.9942 as Chinese equity markets lost up to 3.5% overnight.

Talk of an Asian central banks defending an option strike at $1.3250 in EURUSD (see Options section below) helped the single currency rebound from its lows, while surprising resilience in the German labour market also lent the single currency support.

But the dollar then took another turn lower as risk appetite improved after China announced a cut in bank’s reserve requirements, indicating that Beijing was officially no longer fighting inflation but battling against slower growth. EURUSD moved back above $1.33, while AUDUSD climbed back above parity.

USDJPY movements have lately been dictated largely by month-end flows. Japanese bank demand has been offset by exporter selling holding the market in a Y77.80 –Y 78.10 range.

GBPUSD, which held relatively firm around despite the UK’s bleak economic outlook with the British government laying out another 5 years of spending cuts and increased borrowing in its Autumn Statement yesterday, moved to $1.56 after the Chinese monetary policy move.

The Swiss franc attracted selling interest after the country’s KOF leading indicator came in weaker than expected, raising speculation that the Swiss National Bank could move to lift the floor in EURCHF to 1.25 after its policy meeting next month.

Flows

Dollar buying momentum picked up again in the London morning session as safe haven demand increased following neutral/negative morning news flows and thin liquidity in month-end trade.

Reports indicate support for EURUSD has come from the holder of a large digital option, rumoured to be an Asian sovereign defending a 1.3250 knockout ahead of expiry at today’s New York cut.

Traders have also tipped dollar demand over today's London fix that could prompt a move lower in the pair with several stops below 1.3250 that could open the door to the 1.3145 support level.

EURCHF saw corporate selling around 1.2250 but saw supportive interest following the worse-than-expected KOF result, the leading Swiss economic growth indicator that took EURCHF up to 1.2280.

The FX position for Chinese banks including the PBoC, was net negative CNY24.9 billion in October, the first monthly negative position since December 2007. USDCNY weakened in November as international funds continue to flow out of the country in an increasingly risk averse environment.

Positioning

Morgan Stanley’s positioning tracker, (see explanation of methodology) showed the largest long positions to be in USD, JPY and NZD.

The indicator estimates the largest short positioning to be in NOK, SEK and CAD.

Positioning in EUR is estimated to be short, but has become more neutral due to strong buying from TFX Japanese margin accounts.

Overall positioning score

 
Source: Morgan Stanley


The Bank of New York Mellon’s iflow indicator, echoes increasing USD long positions, seeing strong inflows this week but saw some of the biggest outflows in JPY, compared to last week’s neutral flow. EUR saw minor net outflows.

AUD continued to experience strong outflows for the second week running as did the troubled Hungarian forint.

Options

NY expiry

The main talk in the market this morning surrounds the rumored large digital expiry in EURUSD at 1.3250. Size is all important here, and one chief options dealer says he’s skeptical that this flow is large, given that there hasn’t been a lot of activity through the brokers during the European session, as one would expect that. Another chief trader says he’s not convinced that the holder is an Asian sovereign, and tongue and cheek, adds that it’s a great rumor to spread if you want the level to hold at 1.3250.

Should the EURUSD vol curve be flatter?

Societe Generale notes in its morning report that the EURUSD vol term structure is in an unstable equilibrium. They point out the striking steepness of the vol curve, at a time when ATM vols are elevated. They point out that the historical relationship between 3-month vols and the slope of the curve (1-mth-1-year currently has a positive slope of 1 vol), means 3-month is consistent with a level of 13, not the current level of 16.2. They argue that current levels are unsustainable. Two outcomes are possible for the term structure: either the curve will shift lower, or it will flatten soon, SG adds.

Swaps

The euro forwards market remains under heavy pressure as bank funding issues continue to dominate trading . Funding strains were highlighted as the three-month EURUSD basis swap widened to a fresh high of -162 basis points.

What to watch for

Recycling of emerging market currency intervention looks set to weigh on EURUSD as central banks rebalance their holdings.

Traders noted that the Turkish central bank was in the market driving USDTRY from 1.8600 to 1.8450 on Monday. Straight after, EURUSD came under selling pressure as the bank recycled the flow.

With USDTRY back around pre-intervention levels, expect the central bank to come in again and for EURUSD to come under pressure thereafter.

And Turkey is not alone: Mexico and Indonesia have also been in the market selling dollars, with plenty of other central banks waiting in the wings.

The resulting recycling in EURUSD could add to the pressure on the single currency, pushing it closer to October's $1.3146 low.

Spot, 6.45 EST

 
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