Market reacts to Euro Risk sentiment as Safe havens benefit and stock markets tumble

Tom Tong10/Nov/2011Currency Updates

GBP

  • Sterling hits 8-mth high vs euro as Italy debt worries mount
  • Sterling falls sharply vs firmer USD
  • Concerns about euro zone crisis impacting UK may pressure GBP

Sterling rose to an eight-month high against a broadly weak euro on Wednesday after benchmark Italian bond yields rose to levels widely deemed unsustainable, taking the euro debt crisis to new levels.

However, the pound fell against the dollar, dragged down as investors sought the safety of the U.S. currency and by worries that the crisis in Britain’s euro zone trading partners could push the UK economy back into recession.

Also weighing on sentiment towards the pound, data on Wednesday showed Britain’s trade deficit deteriorated much more than expected in September to 9.814 billion pounds, its widest since the series began in 1998.

The Confederation of British Industry said the risk of another recession had risen as it cut its forecasts for UK economic growth, although it believed Britain could avoid this.

Consistent weakness in the UK economy prompted the Bank of England to adopt further quantitative easing last month, which is often considered currency negative as it involves flooding the market with pounds. Despite this, sterling has held up against a broadly weak euro.

Looking ahead, the key event risk on the day comes in the form of the Bank of England rate decision, although no change is expected on asset purchases or interest rates. As such, most of the price action and direction will be heavily influenced by on-going developments in the Eurozone, with Greece and Italy dominating headlines. A UK Guardian piece hasn’t been helping matters, after reporting that Germany and France have begun talks to consider the breakup of the Eurozone on fear of contagion to the core economy. We highly doubt there is any legitimate realty to this actually occurring, but at the same time recognize the effect such a report can have. Fear is the ultimate market mover and this type of report and rumours of reduced bank exposures, along with record wide bond yields on the peripherals, all contribute to fear of mass contagion and systemic risk that ultimately have the potential to suck any risk out of the global macro markets. It is also worth noting that geopolitical risk has crept back into play with Iran in the headlines on an IEA report that the country is looking at ways to deliver a nuclear warhead.

EUR

  • Euro under pressure after Italian yields spike
  • Political uncertainty in euro zone weighs
  • Capital repatriation seen as one factor helping euro

The Euro licked wounds on Wednesday in its worst one-day beating against the dollar in 15 months after yields on 10-year Italian bonds spiked above 7 percent, a level where the cost of financing a debt burden of more than 2 trillion euros is seen as unsustainable. It extended losses to hit an eight-month low against sterling on Wednesday, as fears about the euro zone debt crisis intensified, with benchmark Italian bond yields rising above 7 percent, a level widely deemed to be unsustainable.

The single currency steadied on Thursday as real-money players stuck to the side-lines after a selloff the day before on a spike in Italian borrowing costs, but options positioning suggested more drops ahead as fears of global financial turmoil grip markets.

Two major clearing houses raised the level of collateral needed for those holding Italian government debt. The move makes it more expensive for holders of Italian debt to borrow against it and looks set to trigger a cycle in which rising yields fuel more fear and more selling.

But with most players expecting further falls, support levels came into focus, with the most immediate one holding up well on Thursday around $1.3525 — an area that provided solid resistance when the euro climbed back up in a corrective short-covering rally from its early October low.

European Commission President Jose Manuel Barroso issued a stern warning of the dangers of splitting the 17-nation currency zone. EU sources told Reuters that French and German officials had held discussions on the matter.

On top of that, Greek Prime Minister George Papandreou said he was stepping down without saying who would succeed him as the nation heads towards bankruptcy.

USD

  • Dollar Responds to Crisis Fears, Liquidity Crunch with Massive Rally
  • Euro’s Troubles Turn from Political Uncertainty to Market-based Crisis
  • British Pound Outpaces all but the Dollar and Yen ahead of the BoE

The US Dollar rode safe-haven demand to break the range top capping prices since the beginning of November as the S&P 500 dropped the most in two months.

For the first time in months, investors and the speculative masses are seriously contemplating the risk of another global financial crisis. Naturally, the shift in sentiment pushes capital from the high yielding, risk-inherent assets to the certifiable safe havens. Yet, there is a fundamental difference in this particular change in tone and those that we have seen in previous tides this year. This time around, there is a clear risk of contagion with the consequences of an evaporation of liquidity readily visible.

This is exactly the right mix of conditions that highlights the greenback’s value amongst its safe haven peers: risk aversion to the point that yield doesn’t even come into the equation (because there is virtually no return to be had with dollar exposure). This particular slant on risk was so intense in fact that the Dow Jones FXCM Dollar Index managed a 1.5 percent rally – the third largest rally for the benchmark in over a year.

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Written by Tom Tong

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