Dollar in demand on North Korean power vacuum

Headlines • North Korean leader Kim Jong-Il dies

• Moody’s cut Belgium’s rating to Aa3 from Aa1 with negative outlook

• Fitch places Spain, Italy, Ireland, Slovenia and Cyprus on negative watch

• ECB President Draghi continues to rule out stepping up the ECB’s SMP bond purchase programme

• China experienced capital outflows as the domestic economy slows

Market reaction

The dollar found support on Monday while Asian currencies dropped sharply as news of the death of Kim Jong-Il triggered a wave of risk aversion in early trade.

The South Korean won lost over 4% and Asian equity markets slumped as fears over the transition of power in North Korea, which possesses nuclear weapons, raised concerns over stability in the region.

USDJPY briefly spiked higher above Y78.00, as traders fretted over the power vacuum on the Korean peninsula although it gave back its gains later in the session.

Haven demand for the dollar pushed EURUSD towards last week’s 11-month low under $1.30, but trading remained largely rangebound, with liquidity drying up as investors approached the holiday season.

The single currency also suffered as European Central Bank Mario Draghi ruled out increased eurozone government debt purchases. News that speculators had built up record short positions in the euro raised the bar for further aggressive losses in the single currency, however.

Meanwhile, rising risk aversion boosted demand for the Swiss franc, with EURCHF trading down to a low around SFr1.2175, before reports that the Swiss National Bank was checking prices in the forwards market pulled the currency pair off its lows.

Flows

EURUSD recovered from the $1.2982 lows reached in the aftermath of the risk sell-off. Interest from Asian Sovereigns brought put a floor in place at $1.30 and bids from interbank names saw EURUSD climb up to $1.3030.

Traders say, despite thin year end liquidity and an unwillingness to take on risk into the year should support the dollar but an already heavily short market could limit the downside. Option expiries between $1.2950 and $1.3050 will dominate spot on an intra-day basis, absent significant news flow.

Firm support is expected at $1.2945 and on the topside $1.3050 should offer short-term resistance. Spot traders at a top-5 bank say order books have become lighter in this range, with significant stops only above $1.3100.

EURCHF hit 6-week lows and triggered a series of stops as it breached the Sfr1.22 mark and hit a low of Sfr1.2175. Short-term and leveraged accounts were Swissie buyers as the risk-off environment picked up following news of the North Korean leader’s death and fears of an imminent rise in the exchange rate floor abated after the SNB’s inaction last week.

In GBP, UK corporate hedging is likely to be a key driver going into the year end as speculative activity reduces. “With this in mind and given the weakness of the euro we have purchased some short-dated EURGBP downside,” said traders at a major European bank.

USDCNY was fixed lower at 6.3303 but spot went through 6.3500 on the news of Kim Jong-Il’s death and as high as 6.3577 on the back of demand from oil importers. Offers from local markets however triggered a sharp fall back to 6.3370.

Positioning

Investors have rebuilt USD longs as year end approaches, reversing the direction seen in last week’s report. Aggregate Dollar positioning is now at a net long of $16.7 billion. Meanwhile, EUR net shorts have reached a record high at -116,257 contracts, outdoing the previous record of -114,00 contracts in 2010.

Meanwhile, commodity currencies AUD and NZD saw a strengthening of long positions while the net short in CAD was firmly reduced.

What to look for EUR based investors that are considering diversification trades in 2012 should consider CAD as an attractive candidate. CAD was the worst performing currency this year, but this is has left the currency undervalued on a PPP basis says Jane Foley at Rabobank.

The Canadian economy remains firmly tied to its larger regional neighbour and recent stronger than expected US data releases are good news for the Canadian economy and its currency. Canada also posted better-than-expected Q3 GDP numbers leading the Bank of Canada to dropping much of its previously extremely dovish rhetoric. The BoC, it seems, is unlikely to cut rates imminently and although the BoC will not be tightening policy for a while, the move is likely to happen before the Fed.

“It would be a brave call to expect the CAD to outperform the USD during a ‘risk off’ environment but the CAD is set to perform better than the EUR when market concerns over the Eurozone are at elevated levels” says Foley.