Headlines
• Central banks in Europe “have started weighing contingency plans to prepare for the possibility that countries leave the eurozone” – WSJ
• IMF denies the Nikkei reports that the US, China and Japan will set up a $600billion lending facility at the fund to “deal with the European debt crisis”.
• Japanese machinery orders fall 6.9% m/m in October versus an expected rise of 0.5%.
• Australian net employment down 6.3k in November versus +10k expected (+10.1k previous); unemployment rate rises to 5.3% from 5.2%.
• Reserve Bank of New Zealand leaves interest rates unchanged at 2.50% as expected
Market reaction
EURUSD remained supported in a relatively tight range around $1.3400 ahead of a couple of days of extreme event risk for the single currency.
The European Central Bank, at its planned policy meeting on Thursday, is expected to lower its main lending rate by 25 basis points to 1%, although a large minority would like a 50bp cut. The ECB is also expected to announce fresh facilities to ease liquidity concerns in the banking system and weaken its collateral rules for banks to obtain funding.
However, the central bank, under new president Mario Draghi, is expected to hold off from announcing any increase in its purchases of eurozone government bonds until it has received assurances over fiscal discipline after the summit of EU leaders.
That summit, which is set to start on Thursday evening and carry on into Friday, remains the focus of attention, with wrangling over measures to contain the eurozone debt crisis dominating trading. Dealers said the constant stream of headlines ahead of the EU meeting was creating headline fatigue, limiting moves in EURUSD for now until actual news of action emerged.
GBPUSD remained supported above $1.5700, after traders reported large M&A-related demand for sterling on Wednesday. The Bank of England is expected to leave interest rates and its asset purchase scheme unchanged at its policy meeting on Thursday.
Meanwhile, AUDUSD lost ground after Australian unemployment rose more than expected, but losses remained contained.
EURCHF moved higher after Switzerland’s finance minister said the country was prepared for a flight into the franc if eurozone problems increased, adding that both capital controls and negative rates were still under discussion.
Elsewhere, USDJPY fell, breaking out of its recent tight range to lows around Y77.40 amid reports of good corporate demand for the yen in Asia.
Flows
EURUSD made an early upward move to $1.3428, but encountered selling from intra-day range traders, which brought the pair back to the $1.3400 territory. Traders at a top-five bank have said the short-term trading community has a preference to be long EUR and even to hold over the weekend, assuming no negative surprises from the ECB.
AUDUSD saw the most activity overnight after poor employment data saw the Aussie lose half a cent to a low of $1.0235. AUDUSD subsequently staged a rally as short-term and intra-day accounts bought AUD, as equity markets strengthened.
Aussie strength continued during the London session on the back of Asian sovereign demand and interest from short-term momentum accounts. Buy stops around $1.0300 and $1.0330 have remained in place through sell interest ahead of these levels.
Asia-based corporate demand saw USDJPY break out of its recent narrow ¥77.60-¥77.80 range around mid-morning in London. With market liquidity thin, USDJPY moved as low as 77.33.
Traders at one bank said they favoured buying USDJPY on dips to ¥77.20/30, with order books suggesting the market will be slightly long around these levels.
Sterling stayed well supported in London after reports of a large M&A-related buy order last night that saw cable hold firm above $1.57 and move EURGBP lower as macro names cut long positions, bringing the pair back to the familiar £0.8520 support level.
Positioning
The Bank of New York Mellon’s iFlow indicator showed outflows in EUR were once again the heaviest out of all currencies, suggesting longer-term, real-money investors were still cutting back exposure to the eurozone.
Dollar inflows remained positive, while risk proxies, such as AUD, CAD, Skandies and EM currencies, showed relatively neutral flows ahead of the coming event risk at the end of this week.
Options
“Generally, implied volatility continued to drift lower as risk sentiment stayed cautiously upbeat, but tensions remain in the front-end ahead of key central bank meetings and expectations from the EU summit this weekend,” say derivatives strategists at Société Générale.
EURUSD one-week vol was up by 0.5 to 15.5, given the uncertainty about what the ECB will deliver, while longer-dated volatility remained firm.
Most G10 one-month vols have been below their median levels during the past six months, while in high-beta currencies, vols were coming off, with AUDUSD one-month vol below 15 for the first time in more than a month.
Elsewhere, the risk of a rise in the EURCHF floor was being felt in the options market. EURCHF one-week was at 16, up by seven and well above realised vol. SocGén strategists said the front-end was likely pricing in a bold move to 1.30, rather than 1.25, given the high premiums.
Swaps
Tensions in dollar-funding markets were still evident, but the stronger-than-expected take-up of funds from global central banks’ swap facilities ensured that stress remained well off its recent peak.
Figures from the ECB showed that 34 banks obtained $50.7billion in three-month dollar loans, while five took $1.6 billion in one-week liquidity.
The benchmark three-month EURUSD cross currency basis swap stood at -115bp, well down from the post-Lehman high of -162bp it hit last week.
What to look for
Thursday’s ECB meeting is something of a dilemma for the currency markets, not least because it sits uncomfortably close to the EU leaders’ summit, at which the survival of the euro could be decided.
A more immediate quandary, however, is the reaction in EURUSD to a rate cut from the ECB – 25bp is fully priced in, but consensus forecasts are looking for closer to a 50bp move.
Ordinarily, a 50bp cut would undermine a currency, but in this case EURUSD could find support from the perception that the ECB was acting to remove stress from the banking system and thus helping to ensure the survival of the euro.
However, without the ECB also committing to additional peripheral eurozone bond purchases, any rally in EURUSD would be a selling opportunity.
Spot, 6.00am, EST
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