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German bond auction result spooks markets

The euro finally breached 1.3440 level proper in Europe and hit a 6 week low of 1.3374 after a dismal result in the German 10-year benchmark Bund auction.

It sparked major fears about the spreading of contagion to Europe’s stronger and larger economies. France’s credit rating may also be under threat because they may be forced to provide a greater share of the bailout funds for Dexia. Option knock-out barriers also starting to exacerbate spot move lower. Separately, investors abandoned long positions in the Australian dollar amid heightened fears that China was joining the global economic slowdown.


Worst demand on record at auction of German 10-year paper

• China HSBC Flash Manufacturing PMI falls to 48 in November from 51 in October

• Eurozone November manufacturing PMI came in weaker than expected and slumped to 46.4 (exp 46.6) from 47.1 in the previous month.

• Dexia bailout may be at risk as Belgium may not be able to meet its agreed share of the rescue, forcing France to increase its share

• Italian bond yields rise above 7%; Italian bond yield now fully inverted, signalling recession

• “Greece faces risk of exit from eurozone” – Bank of Greece

• Bank of England minutes: “While the worst risks had not so far crystallised, the threat of their doing so had increased, exacerbating the already severe strains in bank funding markets and financial markets more generally”

• Obama reopens debate on US stimulus, stepping up pressure on the divided Congress after failure to reach a deficit reduction plan

Market reaction

News of weak demand at a German 10-year bond auction added to the negative sentiment surrounding the euro, which sent EURUSD crashing through previously impenetrable $1.34 support level to a 6-week low of 1.3373. Germany retained EUR2.4 billion on its EUR6 billion auction, the highest retension rate seen since 2008 bringing the bid/cover ratio to 0.67.

The dismal results of the German auction weighed on an already heavy EURUSD, as fears that France would be forced to stump up a greater share of the bail-out funding for Dexia, the Franco-Belgian bank, heightened concerns that Paris might lose its AAA credit rating.

Flash PMI estimates suggesting activity in China’s manufacturing fell to its lowest level in 32 months in November came as markets were still digesting news of weaker than expected US growth in the third quarter, while eurozone PMI data showed the slowdown in the region was deepening.

The Australian dollar took the brunt of the selling overnight dropping to a six-week low against the US dollar as news of a slowdown in China added to concerns over global growth and saw investors cut long positions in the currency.

Other commodity-linked currencies also came under pressure with NZD, CAD and ZAR following the Aussie and global stock markets sharply lower.

GBP also came under pressure as concerns over the UK economic recovery were compounded by a downbeat message from the minutes of the Bank of England’s last policy meeting.

Unsurprisingly, the USD, JPY and CHF all found support from the increased nervousness on financial markets.

Spot, 7.00 AM New York


Options EURUSD

Market talk of a 1.3400 knock-out barrier which expires on Monday which could have a significant impact on EUR gamma. As a result the hedge defined by optional and spot long positions will have to be squared. This mechanism should accelerate the fall in spot, as it will be free to break lower when the barrier will disappear and the long spot position sold back. If we add to this the potential illiquid moves ahead of Thanksgiving, the price action could be really turbulent.

One trader at a Top 3 bank says you would expect to see knock out barriers every 50 pips down as far as 1.25, as there has been alot of bearish structures, such as reverse knock outs and put spreads put on. The partly explains why one-week vols are higher this morning, with 1-week trading 1.5 vols higher at 14.35 today. One-month trading at 15.9 from 15.4 yesterday. Curve remain relatively flat.


Interesting developments in AUD vols. AUD breaks below .9800 on poor Chinese PMI data, and traders not that typically this would see AUD vols and risk reversals move higher, however, the opposite has occurred, with selling pressure at the front end of the curve dominating. That may present a buying opportunity, with Thanksgiving long weekend and no Australian data releases due to the end of the month. Short end vols look cheap relative to the back end

The 1W RR traded this morning at -2.5 for AUD puts, which is a relatively low level compared to the peak at -4.9 we saw on 10 November. If the bearish momentum goes ahead, traders say that it doesn’t necessarily mean higher short dated risk reversals soon because the correlation between vol and spot is now lower than in the past.


Bank of New York Mellon’s iFlow indicator shows, daily FX flow in EUR was half that of the previous day week, while NOK and MXN saw continued to see strong flows.

The iFlow confirms a lack of investor appetite for EM currencies such as the Brazilian Real, Thai Baht and South African Rand which saw continued outflows this week. CEE currencies followed a similar pattern with the Polish zloty and Hungarian forint experiencing the largest outflows this week.

Similarly, commodity currencies, New Zealand dollar and Australian dollar saw negative flows yesterday as global growth fears heighten.


Banks reported a pick up in volume picked up as EURUSD breached the key 1.3420 levels. Overnight, Asian commercial accounts and real money cut back on long positions after risk appetite deteriorated following weak China flash manufacturing PMI while fears over eurozone government finances were exacerbated after news that the Dexia bailout stalled.

Euro downside has so far been disappointing for shorts due to the heavy option defensive bids, technical support, and continued Asian reserve management activity.

But traders say the sharp move in currency along following the poor German bond auction when considered alongside the bearish sentiment and negative headlines today may have shifted the EURUSD range lower as a result.

AUDUSD broke through 0.9800 following the weak Chinese PMI with trader reports of strong selling from a custodial account from 0.9780. Support is tipped at 0.9730 from corporate hedging and option protective bids increase on the way down to 0.9700, where more barrier exposure is tipped.

Elsewhere, heavy two-way flows in USD-JPY have restrained movement around the 77.00 mark, though today's Japanese market holiday also reduced activity.

What to look for

The Chinese data on Tuesday, showing manufacturing activity dropping to a 32-month low does not bode well for the AUD, given the high reliance of the Australian economy on its exports to China.

Positioning also leaves room for the AUD to be tested, given that according to the latest CFTC data, it is, along with the USD and the NZD, one of only three major currencies of which the speculative community is still long.

From a technical perspective, the AUD also looks vulnerable. AUDUSD has broken down through the 100-week moving average at $0.9750 and a weekly close below that level would be the first such close since July 2009.

Technical analysts say that would be a very negative signal for AUDUSD, with the next support level the $0.9388 low from October and beyond that the $0.8760 August 2010 will come into focus.

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