Short-term traders abandon euro

Headlines • Italy sells €4.75 billion at bond auction, the maximum amount planned; yields on three-year note lowest since September sale but yields on 2018 notes rise to 5.75% from 5.62% at previous sale

• Eurozone banks deposit a record €489.906 billion in the ECB overnight facility

• Eurozone trade surplus beats expectations, rising to €6.9 billion in November from €1 billion in October

• UK producer price inflation drops more than expected in December, falling to 4.8% from 5.4% in November

• Swiss National Bank expects profit of SFr13 billion for 2011 financial year; SFr8 billion from FX positions

• China’s FX reserves drop by $20.6 billion in the fourth quarter to $3.181 trillion

Market reaction and flows

USD The dollar continued to come under more pressure overnight as risk appetite held up after encouraging debt auctions from Spain and Italy on Thursday, and anticipation of yesterday’s success to be replicated in Friday’s Italian auction.

Italy’s bond sales provided mixed results, with borrowing costs in short-dated bonds lower but yields on longer tenors up, dampening a perhaps overly bullish morning market and allowing the dollar to regain some ground.

EUR The euro’s short squeeze rally in which EURUSD reached an overnight high of $1.2879, after French media reports claiming a private sector Greek debt deal was due in coming days, was reversed during the London session. EURUSD dropped to $1.2788 lows after the Italian auction, as short-term longs closed positions and corrective action was noted in the euro crosses that had also been bid overnight in Asia.

While Draghi spoke confidently on Thursday about the effectiveness of the ECB’s LTRO operations in “unclogging some of the financial channels in the European banking sector”, such as reopening the unsecured bank funding market, he provided little comment on the continued risk aversion implied by banks’ record use of the ECB’s deposit facility, something likely to weigh on markets.

Traders say the lack of sustained EUR upside on improved eurozone sentiment during the past day or two may be a signal of more downside pressure. Furthermore, if support at $1.2770 gives way then short-term stops may hasten a move towards $1.2700 from which EURUSD rebounded on Thursday.

GBP GBPUSD tripped stops over $1.5400 but cable’s rally soon ran out of steam as it hit offers from Middle Eastern names, and a reportedly large EURGBP buy order from a UK clearer sent the cross up to £0.8370 from £0.8350 as GBPUSD drifted back down to $1.5340.

The UK’s economy, while far from healthy, has enjoyed marginally better-than-expected December data and greater optimism from UK chancellor George Osborne, though Q1 2012 is widely expected to show weakening UK data.

December PPI fell more than expected to 4.8% y/y, though there was little effect in the market.

Order books show Sterling traders and fund names are still looking to sell rallies amid a weak technical backdrop and increased risk of QE from the Bank of England, as falling price pressures seem to be taking shape.

CHF EURCHF encountered selling from fund names from Sfr1.2120, bringing the pair down to Sfr1.21 where substantial strike congestion lies. Traders say option barrier support ahead of 1.2075 will put a floor in place. UBS says we may be at levels where investors will have more appetite to test the floor, though say the SNB will still be keen to defend the Sfr1.21 figure and might come in, in force, if we see a prominent break below this level.

AUD Demand for the commodity currencies was underpinned by relatively firm risk sentiment as they traded within their recent ranges. AUDUSD volatility soon picked up in London session, where it reached an overnight high of A$1.0360 and swiftly encountered sell orders. Aussie has held firm above A$1.0330, though traders say order books show strong resistance above $1.03070 will prevent a move through A$1.04.

Positioning

Morgan Stanley’s FX Positioning Tracker showed heavy selling in the EUR this week, with the market moving deeper into short territory.

The move was driven by the margin-trading community on the Tokyo Financial Exchange (TFX), which halved its long EUR position since the end of last week.

While still neutral, AUD positioning is approaching long territory, as TFX accounts were buyers intra-week and positive sentiment increased.

The largest long positions are in USD, JPY and SEK. The largest short positions are in EUR.

Options

EURUSD realised volatility is below 10, sovereign yields are plummeting and the euro is disconnecting from risk metrics.

This has thrown up some interesting pricing behaviour, which seems to indicate that the market is less enthusiastic about employing downside strategies that have not always been successful.

Consider the fact that the current one-month risk reversal is -0.65, with euro now trading under 1.30, yet when spot was trading 1.40, the risk reversal was trading in and around -4 vols. To be sure, the front end of the curve has been influenced by exotic pressure. (See chart 1)

That exotic pressure is because investors have bought a lot of puts with RKOs, making the market makers long of the digital risk (the counterpart of the KO is that market makers are long of one-touch options). The hedge for being long OT requires market makers to sell a lot of downside vanillas to match the vega profile of the exotic, which also earns a lot of upfront option premium to offset the fast time decay of the OT. It is this dynamic that has weighed on short-end vols.

It should be noted, however, that risk reversals at the long end have also come off. The one-year risk reversal has collapsed as well, currently trading around -2.3. So the skew returned to its level of June, while spot is much lower.

Thus, euro vols appear to be moving into a new pricing regime, says Société Générale. Its conviction is reinforced by the signal change in the correlation between spot and implied vols, which have now turned positive. In a note on Friday, the bank says, from a trading perspective, the mean reversion to the standard pattern might be strong so buying risk reversals on current levels is an extremely good entry level. (See chart 2)

What to look for: More pain for EURUSD

In light of the recent rally in short-end eurozone peripheral bonds, there is room for further short-term gains in EURUSD.

That said, the outlook for EURUSD in the longer term is less bright.

Peter Von Maydell, head of currency research at Credit Suisse, says the prospect of additional monetary easing from the ECB suggests that interest rates’ support for EURUSD is likely to wane in the coming weeks.

“As such, we remain bearish on the euro and have revised our EURUSD forecasts from $1.25 to $1.22 in three months and from $1.26 to $1.24 in 12 months,” he says.

Spot, 6.45am, EST