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Foreign Exchange

Euro rallies as ECB steps up to the plate

After a sell-off in Asia as fears over the future of the eurozone escalated, EUR staged a recovery after heavy bond buying from the European Central Bank, but sentiment towards the single currency remains fragile.

Headlines • European Central Bank reported to be aggressive buyer of eurozone government bonds , with traders estimating EUR1 billion of purchases

• Netherlands prime minister Rutte says “it should be possible” for countries to be removed from the eurozone

• Greek bondholders make proposal for bond swap to Athens, terms include 50% debt reduction only if new bonds have high interest rates.

• UK unemployment hits highest level since 1994 at 2.62m

• Bank of England slashes growth forecast and warns prospects for the UK economy have worsened

• Bank of Japan lowers economic assessment from October, saying “pace of economic pick-up more modest.”

• China’s commerce ministry warns it is not optimistic about exports going into year-end and early 2012

Market reaction

Pressure on the EUR continued in Asian trade, while haven demand boosted both the USD and the JPY as worries over the turmoil in eurozone sovereign debt markets and the spillover effect on global growth intensified, sending stock markets in the regions sharply lower.

Renewed anxiety over the future of the single currency has seen contagion spread increasingly to the core of the eurozone. Not only have Italian and Spanish bonds come under pressure, but also Austrian, Belgian and Finnish bonds have sold off, while speculation over a downgrade of French debt have done little to support the single currency.

But EURUSD staged a recovery in the European session as reports of heavy bond buying, principally of Italian debt, from the European Central Bank helped to push sovereign yields lower and stablise sentiment. EUR followed European equities higher, while other riskier currencies like the AUD, CAD, NZD also recovered from their earlier sharp sell-off against the USD and JPY.

Still, the chances of a sustained rally in the euro look remote as the wrangling among policymakers over whether the ECB should be the lender of last resort to debt-stricken eurozone countries continues. That pessimism was reflected in the options market, where the cost of insuring against EURUSD downside with a one-month risk reversal closed in on a record high.

GBP failed to gain traction after the Bank of England cut its growth forecasts, warning that the absence of a credible and effective response to the eurozone debt crisis was the single biggest risk to the domestic recovery. The gloomy assessment is likely to be a green light for further quantitative easing in the UK.

Spot, 7.00 AM New York

EUR: Current: 1.3480 Open: 1.3445 Support: 1.3408 Resistance: 1.3729

GBP: Current: 1.5755 Open: 1.5765 Support: 1.5620 Resistance: 1.5840

EURGBP: Current: 0.8548 Open: 0.8530 Support: 0.8510 Resistance: 0.8590

CHF: Current: 0.9182 Open: 0.9210 Support: 0.9080 Resistance: 0.9345

EURCHF: Current: 1.2375 Open: 1.2375 Support: 1.2330 Resistance: 1.2470

JPY: Current: 76.95 Open: 77.00 Support: 76.90 Resistance: 77.65

EURJPY: Current: 103.64 Open: 103.50 Support: 103.30 Resistance: 106.50

AUD: Current: 1.0113 Open: 1.0100 Support: 1.0050 Resistance: 1.0200

NZD: Current: 0.7650 Open: 0.7660 Support: 0.7500 Resistance: 0.7750

CAD: Current: 1.0275 Open: 1.0260 Support: 1.0190 Resistance: 1.0365

EURSEK: Current: 9.1290 Open: 9.1250 Support: 9.0900 Resistance: 9.1600

EURNOK: Current: 7.7877 Open: 7.7800 Support: 7.7450 Resistance: 7.8200

Options

EURUSD 1-month risk reversal now trading 3.9 favoring euro puts, after trading near a record of 4.2 last week. Traders see continued demand for downside strikes from both FX participants, and non-traditional FX players, a continuation of a trend that first emerged last week, as hedgers from the equity and credit markets look to protect negative event/tail risk in Europe.

Trader says strikes generally in demand between 1.20 and 1.25, with some 1.22 strikes dealt in the European morning.

In a report today Societe Generale, says much of the pressure is built up in the short end. Their analysis on the metrics of contagion risks within the context of the volatility threshold and concluded that contagion effects can be observed provided that the EURUSD 1-year vol exceeds 13.8. “We are evidently in the contagion area since the curve is trading on either side of a pivot at 16: 1M vol is at 16.2 and 1Y at 15.9,” says SocGen’s option strategist, Olivier Korber.

Swaps

The dollar is gaining support from tightening US dollar liquidity conditions as funding strains continue to tighten at European banks. The premium paid for US dollars in the basis swap market has continued to increase reaching its highest levels since the peak of the global financial crisis in late 2008.

Positioning

Bank of New York Mellon iFlow indicator shows recent weeks have seen steady outflows from the EUR from portfolio managers, while the souring outlook for global growth has led to net selling of AUD, NZD and NOK in recent trading sessions. The bank says global money managers are looking to reduce riskier exposure and are likely to remain on the sidelines and refrain from drawing on elevated cash levels.

Flows

EURUSD is being whipped around and susceptible to any news on European periphery.

Traders say downside remains the favoured direction, and prefer to sell rallies.

Offers seen at Tuesday’s high of 1.3550, and likely to struggle to breach 1.36, they say.

Macro funds heavy sellers, but petrodollar recycling from the Middle East and Asian central bank bis seen around 1.3450.

GBPUSD. Lots of talk about GBP breaking down after breaching important support level of 1.5820 and bearish news of rising unemployment and downgrade of inflation forecast which opens up the increased possibility of QE, traders say.

However, reserve manager buying has been seen today by some banks, who argue they are the position of strength rather than those looking to push cable lower on the technical break.

AUDUSD. Offers at 1.0200 and traders say don’t be short below 1.0050.

What to look for

The US inflation report should confirm that headline inflation pressures are close to peaking. Core pressures should remain firm, however, which should limit the scope for USD weakening QE3 to be launched by the Federal Reserve before the year end.

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