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Foreign Exchange

Weekly highlights

Acropolis now: Athens threatens to derail the euro
 

Greece once again dominated trading in the euro this week as speculation over whether Athens could avoid a disorderly default of its debt continued.

The confidence that followed the agreement at the end of last month over a fresh rescue package for Greece faded after George Papandreou, Greek prime minister, shocked investors by announcing that he planned to hold a referendum over the bailout deal.

The news came as a potential blow to the euro project as leaders gathered for a G20 meeting in Cannes, prompting German chancellor Angela Merkel and French president Nicolas Sarkozy into action to persuade Greece not to derail efforts to contain the eurozone debt crisis.

The euro lurched lower as investors feared that the problems in Greece would not be contained and would spread to other larger eurozone debtor nations.

That put the spotlight on Italy, with the yield on Italian government bonds climbing to a euro era high on Thursday, pushing them to levels that many believe put Rome on an unsustainable debt repayment path.

 

The single currency also suffered on Thursday after the European Central Bank ushered in a new era by delivering a surprise interest rate cut after its policy meeting, lowering its main lending rate by 25 basis points to 1.25%. Many took the move as a change of tack from the central bank as Mario Draghi, former governor of the Banca d’Italia took over as president of the ECB following departure of France’s Jean-Claude Trichet . They said it was an indication that Draghi could be a more pro-active leader than his predecessor as the threat of recession looms over Europe. The effect of the ECB’s more dovish stance quickly passed, however, as markets turned their attention back to the political horse trading in Athens.

After many contradictory reports flashed across traders screens, it eventually emerged that Mr Papandreou had abandoned the idea of a referendum, a trigger for the euro to recover some poise and haven demand for the dollar to ease even as he still faced a vote of confidence in the Greek parliament .

The euro, which had traded as low as $1.3620 against the dollar on Thursday, rebounded to stand at $1.3840 on Friday.

Euro still vulnerable

Jane Foley, senior currency strategist at Rabobank, said the prospect of a messy default in Greece was less than it was at the start of the week when Mr Papandreou first touted the notion of a referendum.

“While this news may justify the better tone of EURUSD relative to its position earlier this week, it is clear from the huge amount of political uncertainty engulfing both Greece and Italy at present that this crisis still has the capacity to throw a lot of mud at the euro in the comings week,” she said.

“The fact that the market is positioned short of the euro is giving it the appearance of resilience. However, the euro remains clearly vulnerable and downside risk in the coming months remains.”

BoJ Intervention: Success story or drop in the ocean?

The Bank of Japan’s intervention on behalf of the Ministry of Finance on 31 October is widely thought to have been the largest ever one-day intervention of any central bank on record. Consensus estimates of Y8 trillion ($103 billion) flooding the market sent USDJPY up to highs of Y79.55, up from post-war lows of Y75.35 hit earlier.

USDJPY quickly retraced its move higher, however, and has since traded in a narrow range Y77.80 – Y78.05 range.

What to expect next from Japanese authorities depends on whether their objectives are to defend the yen from Y75 or attack Y80.

“We think that they intervened in the market to support the Y75 level, rather than target Y80” said Issei Suzuki, Tokyo-based strategist at Citi

“If the goal Japanese authorities is to push USDJPY higher, there would need to be a significant change from their previous tactics but we believe that such a departure, involving large, repeated bouts of intervention, is unlikely” said Suzuki.

While USDJPY has traded in a rock-solid range around Y78 the recent trend of a strengthening yen is unlikely to reverse and analysts expect the pair to drift lower as global risks still remain.

Yen likely to stay in demand

 

Japan’s government intervention to sell its currency twice in less than three months has coincided with China’s and other Asian country’s increased purchases of Japanese bonds. The effect of these interventions has therefore been offset as Europe’s ongoing sovereign debt turmoil saw reserve managers target the yen to diversify their reserve holdings. Continued doubts surrounding the euro may see the yen supported by these sovereign flows. Meanwhile, Japan’s deflationary environment will continue to support the yen as real yields on Japanese bonds remain among the highest of any developed country.

Since The Bank of Japan cut its inflation forecast to zero last week, the benchmark 10-year Japanese government bond now offers investors the full 0.99% yield, the highest G7 real yield other than Italy’s 2.79%.

Options: BoJ kickstarts volatile week

It was a volatile week in the options market, which began right from the get go after the BoJ intervention on Sunday evening. USDJPY vols rose sharply, trading some two vols higher to peak at 13.25%, while the back end of the curve was softer. By the end of the week the front end was back trading at 10.5%. Traders say that they’ve seen increasing interest from clients to buy structures with barriers at Y77.00 as BOJ jaw bones its determination to weaken the yen over time.

EURUSD vols finished the week softer after a volatile week, with the on-and- off again Greek referendum whipsawing the market. One-month vols which traded as high as 16% on Tuesday were back trading at around 14.5% Friday. Traders report that client interest has been “light” this week, particularly since many players had been stopped out of the market in the move up to $1.42, and have been hesitant to get back in. As a result positioning in the EURUSD isn’t considered heavy.


EURUSD 6m 25-delta implied volatlity
 
 Source: Bloomberg

That said, there has been some interest, traders say, in EURUSD downside in the 6 month tenor, where risk reversals have provided good value in the form of RKIs. That’s because while implied vols have come off from their peak, risk reversals in favour of EURUSD puts haven’t come off as quickly. 6-month risk reversals were trading around 4.2 in favour of puts today in London.


 EURUSD 25-delta risk-reversals
 
 Source: Bloomberg
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