Stand and deliver: markets look to Berlin and Paris

Headlines

• Merkel calls for EU treaty change to introduce as quickly as possible a legally binding set of rules for the eurozone’s fiscal union

• Sarkozy: France and Germany support a new treaty to tighten fiscal discipline and promote economic convergence in the eurozone

• Eurozone banks borrow €8.64bn from the European Central Bank overnight on Thursday, the highest amount since March

• PBoC says home prices in China are “at a turning point”

• Swiss retail sales fall 0.2%, confounding expectations for a flat reading

• Japanese capital spending falls 9.8% in Q3 versus 7.8% fall in Q2

• S&P downgrades large Australian banks by one notch to AA- from AA

Market reaction

The euro consolidated its recent gains on Friday amid cautious optimism that eurozone leaders were finally addressing some of the issues that have undermined investor confidence in the past few months.

Signs that Germany and France were pushing hard for an agreement over fiscal discipline within the eurozone supported the single currency, while hopes that the European Central Bank might take a more aggressive approach to its government bond buying programme also helped to stabilise sentiment.

That said, with equities headed for their best week since 2009, currency markets are not displaying such exuberance, with EURUSD failing to sustain gains above $1.3500. This would suggest that investors remain sceptical that eurozone leaders can hammer out a deal to finally find a resolution to the debt crisis at a summit on December 9.

While investors are monitoring developments in Europe, the main focus on Friday is on the US for a change. Non-farm payrolls figures are expected to continue the recent run of positive economic news from the US, though, again, traders remain on guard for any disappointment. The dollar remained on the defensive, however, as rising stocks weighed on haven demand for the currency, with GBPUSD staying close to $1.5700 and growth sensitive AUD, CAD and NZD all holding on to their recent sharp gains. USDJPY remained in a tight range, however, hovering around the Y78 level.

EURCHF remained in focus after a sharp rally on Thursday amid speculation that the Swiss National Bank was preparing to raise the floor to 1.25 after a flurry of disappointing Swiss economic data. Weak retail sales on Friday only added to the speculation.

Positioning

Despite this week’s short squeeze and a consolidation of positions as year-end approaches, indicators from leading banks still suggest the market is net short of EUR.

Morgan Stanley’s latest positioning tracker, which estimates positioning in G10 currencies between November 28 and December 1, shows the largest short positions are still in EUR.

The bank’s positioning estimates, comprising six proxies, showed the biggest intra-week move to be in EUR driven by internal flow and TFX selling.

The largest long positions are in USD and JPY.

The market is in neutral territory in NZD and CHF, while GBP positioning moved from neutral to short as all proxies indicated sterling selling.

Contrary to some of the positioning indicators from FX banks, Morgan Stanley’s tracker estimates positioning in the oil and commodity currencies NOK, CAD and AUD to be slightly short, with internal and TFX flows indicating selling in these currencies.

Flows Traders at a top-five bank reported substantial buying in EURUSD from directional accounts but despite shallow liquidity, EURUSD failed to break through the $1.3500 mark.

With substantial event risk lying ahead and the market treading cautiously, dealers expect the familiar $1.3420-$1.3500 range will continue ahead of the US non-farm payrolls figures.

There was a subdued session overnight in USDJPY, with banks light order books. EURJPY continues to move higher, with orders suggesting a positive NFP figure might see EURJPY break through Y105.00 resistance up to Y106.20.

There was quiet traffic in AUD, with bids around 1.0150, particularly from model accounts, offering support above parity, while topside remains mixed. Positive NFP figures might meet resistance at the 200-day-moving average at $1.0412.

EURCHF bids on the back of news the Swiss government is willing to support the SNB in weakening the franc, with possibility of negative interest rates.

Reports of retail demand saw EURGBP break through£ 0.8600.

In EMFX, traders reported heavy sell interest in USDZAR by corporates and hedge funds.

Swaps

Funding strains continued to be evident, as figures from the ECB showed eurozone banks borrowed more than €8 billion in overnight funds from the central bank on Thursday, the largest amount since March.

The figures show that only the strongest banks in the region can obtain funding from the market at present.

EURUSD cross-currency basis swaps reflected the strain in the market, widening out to stand at -125 basis points from -116 on Thursday. However, this was still far short of the post-Lehman high of -162bp notched up ahead of the move on Wednesday by global central banks to inject liquidity into the financial system.

Options

Realised volatility remains under pressure after Wednesday’s move by global central banks to inject dollar liquidity in the financial system and on renewed hopes of a solution to the eurozone debt crisis.

The subsequent stabilisation in risk appetite, combined with a fairly stable dollar after its sharp drop on Wednesday, has kept implied vols under pressure particularly in long tenors.

The EURUSD curve is trading between 14.3 and 15.7 from one-month to one-year expiry, with risk reversals little changed.

“We don’t see particular pressure in front-end vols ahead of non-farm payrolls this afternoon, but a good number may be an additional catalyst to accelerate the fall in vols,” says Olivier Korber at Société Générale.

What to look for

In an environment of weak asset markets, contrarian Japanese retail investors have liquidated EM exposure in high yielders such as BRL, repatriating into safer JPY denominated assets.

If risk sentiment improves, Tokyo based-strategists at Citi say Japanese retail investors will shift their assets not back into EM or European assets but into relatively safer smaller G10 currencies and AUD in particular.

This is a pattern already being seen by Japanese fund managers who have reduced European exposures and are overweight CAD, AUD, NOK and SEK.

G10 smalls offer an attractive medium term risk/reward ratio and once sentiment recovers, funds are likely to allocate further funds away from JPY-denominated assets.

Similarly, Japanese retail investors, who continue to favour high yielders, may shift their focus to these less risky investments going forward instead of, still vulnerable, EM currencies.

Spot, 7am EST