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Foreign Exchange

Euro short squeeze risk increases

Traders say the short euro pain trade is dominating with the euro being squeezed on many EM crosses. The dollar’s recent ascent ran out of steam as risk appetite made a tentative return to global asset markets.

Headlines • US bi-partisan “super committee” fails to strike an agreement on a deficit reduction deal

• S&P, Moody’s and Fitch affirm US credit rating

• Tackling UK deficit behind schedule according to Financial Times

• UK Public Net Borrowing Requirement decreased to £6.5 billion in October from £7.7 billion a year ago

• MoF’s Azumi says idea to buy foreign bonds under a new government fund totalling JPY50 trillion would in effect be equal to conducting a “yen-selling” forex market intervention, and would thus “not be acceptable”.

• Good demand seen at short-term Spanish bill auction, though yields sharply higher

• Swiss October trade surplus widened to CHF2.15billion from CHF1.85billion in September

• World Bank cuts forecast for economic growth in China this year and in 2012, citing the impact on the economy from the global debt crisis.

Market reaction

The dollar came under pressure as risk appetite bounced back overnight, with Asian stocks recovering from early losses and European bourses breaking their recent losing streak.

A slight easing of tensions in government debt markets also helped EURUSD to find support as yields on peripheral eurozone paper stabilised and Spain saw decent demand at a short-term bill auction.

AUD along with other risk-correlated currencies bounced back after sharp sell-off on Monday, with reports of Asian central bank recycling of earlier intervention flows keeping the pressure on the US dollar.

Reports in the Japanese press that Tokyo was considering setting up a fund to purchase foreign currency assets saw USDJPY spike higher to Y77 on heightened intervention fears. The yen recovered some poise after Japan’s finance minister played down the idea, however.

Sterling remained under pressure as worries over the UK government’s finances persisted following a warning from prime minister David Cameron on Monday that controlling Britain’s debt was proving harder than anyone envisaged.

The Swiss franc found support as stronger than expected trade figures lessened expectations that the SNB would intervene to raise the floor in EURCHF in the near term.

Spot, 7.00 AM New York

 


Positioning

Morgan Stanley’s positioning tracker, updated on November 21, shows positioning in AUD and GBP and NOK moved significantly since November 14.

GBP and AUD have moved from neutral to short, as Morgan Stanley flow and TFX accounts mirrored the selling seen on the IMM. Deutsche Bank says the short in AUD, which is the largest short in 12 months, remains firm.

The data shows the largest long positions to be in USD, JPY and NZD. The largest short positions are in EUR, CAD and SEK.


 MS FX Positioning Tracker

 
 Source: Morgan Stanley

Flows

Asian FX rebalancing flows are an early influence in Europe, which has lifted EURUSD to resistance level of 1.3540. Strong buying in EUR/crosses such as ZAR, TRY and Asian currencies lending some support to EURUSD.  Traders say the pair will find firm resistance at the 1.3585 level.


Asian rebalancing helped AUDUSD move back to 99.00 but short-term sellers pounced on the rally which saw the Aussie hit an early low of 0.9830. The pressure also came from active AUDUSD selling from Japanese banks. “Bids are seen ahead of 0.9800, which should lend a bit of support on the way down”, says one trader a top-tier bank. Real money demand lifted EURGBP to 0.8660 and buy stops were tripped at 0.8550. Cable heading back towards Monday’s 1.5610 low after GBPUSD saw several offers around the $1.5700 level.

Options

European session saw large buyer of 1-year at-the-money upside strike, in what traders believe could have been a 1 billion euro trade. The buyer paid several market makers. Market impact has been surprisingly muted. 1-year vols trading a spread higher, opening up at 15.9, and trading in the brokers at 16.2 after the trade. Option traders say market was static through the morning, and market seems to have been able to absorb the flow.

Interesting to also note that EURUSD vol curve (1-month-1-year) had been around flat, before the large 1-year trade. However there seems to be a steepening bias, with long end payers and short end realised vols in freefall ahead of the Thanksgiving holiday. That said, one options strategist says that this is unsustainable, especially in the short end, because realised volatility in fact tends to rise on the back of illiquid moves.

Therefore, one recommended trade is to buy delta neutral short-dated options, while the vega (1-year vols trading at 16.2) looks expensive while spot remains above 1.3500.

What to look for

Sterling is starting to look vulnerable as the UK government admits that its deficit reduction plan is proving harder than first envisaged.

Signs that the UK coalition government is shifting away from “plan A” in its aggressive drive to rein in spending have been drip fed to the market ahead of the chancellor Osborne’s half-year autumn statement next Tuesday.

Prime minister David Cameron said the government’s targets were being threatened by the deteriorating economic outlook, talking of a “chronic debt-driven recession” and cabinet member Kenneth Clarke warned about the threat posed by the worsening conditions in the eurozone.

It is not a great leap to imagine that the UK government knows something the market does not and, equally, it looks like it is preparing to deliver some bad news.

Expect Osborne to lower growth forecasts and warn that deficit reduction plans are behind schedule. Expect the pound to lose some its so-called haven appeal.

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