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Foreign Exchange

Weekly highlights: Euro on the brink as debt crisis worsens

Teflon euro: single currency’s resilience a conundrum

 EURUSD (hourly chart)
 

The euro suffered but failed to break significantly lower as the eurozone sovereign debt crisis took a fresh turn for the worse this week. EURUSD , which traded as high as $1.3721 on Monday, sold off sharply as speculation over the break-up of the single currency heightened.

It made repeated attempts to break lower through $1.3420, but remained thwarted even as Spanish and French government bond auctions fared badly and contagion continued to spread across sovereign debt markets in the region.

Reports of aggressive buying of Italian and Spanish government debt from the European Central Bank helped sooth some fears over an imminent breakdown in the region’s financial system, but continued wrangling over the ECB’s role as a lender of last resort for debt-stricken nations did little to foster hopes that policymakers would find a lasting solution to the crisis.

For four days in a row, the EURUSD threatened to push lower, but each time it bounced off its low.

Market positioned for euro losses

Part of the reason why the euro failed to break lower through the support around $1.3420 was that investors had already built up large short positions in the currency, with major banks reporting that bets against the single currency were close to record levels.

By Friday, Kit Juckes, head of foreign exchange research at Societe Generale, said the euro bears were getting tired.

“For the euro, that’s a recipe for some short-covering,” he said. “Unlike bond markets, which are reliant on a constant inflow of money as governments finance their deficits, EURUSD only falls if there are active euro sellers. The market is already short and bearish.”

Reasons to be cheerful

But there are other reasons to be cautious over further losses for euro.

First, the ECB unlike other major central banks has not - yet - turned to the printing press and engaged in quantitative easing.

Second, there is a view that whatever happens to the euro, should it break up, it will have a strong Germany at its heart.

Michael Derks, chief strategist at FxPro, said it could be argued that slowly but surely, Europe was fixing some of the endemic structural problems that have weighed on it for so long, namely the lack of competitiveness and high debts among the fiscal miscreants in the eurozone.

“There is still a very long way to go, and it could still all fall down, but for now there are enough investors who have not yet completely abandoned hope, and, sovereign wealth funds remain desperate to diversify out of their ceaseless dependence on the dollar,” he said.

Pound weathers the storm

On the face of it, it should have been a dismal weak for the pound with lower than expected employment figures and a gloomy Bank of England report, in which the Bank lowered its growth and inflation forecast and opened up the possibility of yet more quantitative easing.

Furthermore, in an interview in Friday’s Financial Times, Bank of England MPC member, Martin Weale said there is a “very strong case” for extending Gilt purchases into next year unless the outlook improves. He added that it was “perfectly possible” the UK economy was already contracting.

 EURGBP (hourly chart)
 

Yet despite a poor week of data releases, rising retail sales notwithstanding. the pound held firm against the euro and did not retrace its recent appreciation against the single currency, continuing to trade around £0.8550. Cable was down from its highs of last week, but was driven largely by moves lower in EURUSD. GBPUSD ended the London session trading at $1.5770. Some have called into question using conventional wisdom of QE being a currency negative for sterling - the pound has in fact appreciated on a trade weighted basis by nearly 2.5% since the Bank last announced an increase in asset purchases.

Analysts have said as global growth slows down, currencies will be driven more by real yields, and less by growth. For this reason the combination of falling inflation and subsequent rise in real yields could in fact support the pound, in particular against the euro, despite the increased likelihood of further quantitative easing in the UK.

Aussie’s outperformance of commodity currencies coming to an end

The Australian dollar has been on a steady path lower this week against the dollar but in comparison to other risk proxy currencies, has begun to underperform, a trend which analysts say will continue.

Deutsche Bank said it recorded the shortest position on the AUD for more than 12 months, quite a turnaround for the currency which until recently held on to a strong long position despite the ongoing turmoil.

Adding to the pressure on the Aussie, National Australia Bank lowered its forecasts for the nation’s economic growth on Friday, saying manufacturing was declining and exports fell more than expected in September.

The bank estimates the economy grew 0.9% last quarter and will grow by an average of 1.7% for 2011. The Melbourne-based previously expected third quarter growth of 1.2% and an annual 2% expansion.

The Australian dollar dipped below parity on Friday for the first time since October 12, as weak Chinese equity markets and lower commodities prices compounded moves higher in the dollar against the euro and other high beta currencies.

The Australian dollar felt the bounce back in risk appetite in October more strongly than other high beta currencies, as European policymakers appeared to be making progress in efforts to contain the eurozone debt crisis, but this outperformance has now begun to correct itself.

“Aussie outperformed, during this period and we are now seeing a bit of a catch up in other currencies, particularly as the rates outlook in Australia looks set for future cuts” said Henrik Gullberg, FX strategist at Deutsche Bank.

While the Australian dollar’s short term moves against G10 currencies will be largely driven by short-term swings in risk appetite, it now seems likely to lag against some its high-beta peers, such as MXN, NOK, and particularly CAD, currencies it outperformed last month.

 AUDCAD (hourly chart)
 

“If you want to remove the risk-sentiment component, it’s quite useful to look at crosses like AUDNOK, AUDMXN, AUDCAD and we like being short AUD against these sorts of currencies” said one trader at a top tier bank.

As some of this correction takes place, and the currency becomes more vulnerable to the possibility of a slowdown in Chinese growth, and further interest rate cuts, the Aussie may well continue to come under pressure.

Options: Bets on EURUSD downside trimmed back

EURUSD vols finish the week slightly softer. One-month vols traded up as high as 16, but drifted back to 15.5 as the week draws to a close.

The dominant theme this week has been option traders’ gamma positioning compared to previous weeks, which gave a strong indication that currencies would be range bound this week. The other notable highlight was at the front end of the curve where 1-month risk reversals, in favour of puts has fallen from 4.2 to 3.6 over the week.

Traders put this down to the fact that EURUSD spot has lacked a clear direction (though it should be noted the currency has continued to make lower highs this week in a range of 1.3721-1.3429). This has resulted in less demand for downside protection, while the markets gamma positioning favouring the downside, means any moves lower in spot were curbed and gradual.

But perhaps the most significant factor likely to drive vols and positioning is the gap between realised vols and implied vols, say some traders.

For example, 1-week realised vols currently trade at 12.25 and 1-month at 13.25, while their implied equivalents trade at 15.6 and 15.8. So with actual vols trading at 3 vols lower in the one-week, long gamma positions are likely to come under pressure.

“At some point, when people are long gamma, then they’ll have to start thinking very carefully as to what actual vols are, otherwise they’re going to start losing money each day if it’s not realising enough,” one head options trader tells EuromoneyFXNews.

Traders eye vulnerable SEK

The latest flavour of the month in options this week has been interest in EURSEK topside, which traders say is the next expression of market stresses and a continued risk-off move.

Deutsche Bank notes that USDSEK is usually more correlated to the equity markets, though at a higher vol base, the market seems less inclined to take the view there. However, the EURSEK 1-month correlation has approached highs reached in July (the correlation data goes back 12 months), though longer term the correlation between EURSEK and the CAC and DAX is more constant at 50% over the last two months.

 1 month EURSEK correlation to CAC, DAX, S&P
 
 Source: Deutsche Bank
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