Commodity Currencies Surge on Unsubstantiated Euro-zone Hopes

Fundamental Headlines

• Central Banks Ease Most Since 2009 – Bloomberg

• OECD Cuts Growth Forecasts, Citing Doubts about Survival of Euro – Bloomberg

• IMF Denies in Italy Aid Talks – Reuters

• Euro Rises after Belgian Auction – WSJ

• Europe’s Leaders Pursue New Pact – WSJ

European Session Summary

The U.S. Dollar headed into the weekend with some significant tail winds: the Euro-zone crisis appeared to be spiraling out of control and global equity markets defied history by posting a losing week during the Thanksgiving holiday in the United States. Still, the collective move lower by higher yielding currencies and risk-correlated assets last week was suspect at best, as the lower participation rates – as indicated by volume on the S&P 500 – suggested that the sell-off was frail and could easily be reversed. Indeed, this was the case, with the safe haven currencies sinking by over 1.8 percent against the commodity currencies in the overnight session ahead of trading in New York on Monday.

The rally was boosted in the overnight by better-than-expected bond auctions from Belgium, France and Italy. In fact, the results of the Belgian bond auction were particularly encouraging, considering the country had its debt downgraded by Standard and Poor’s on Friday. Still, given the significant divergence between credit markets, currencies and equity markets – bonds are suggesting this rally is overdone – there are signs that the relief from trading in Asia and Europe might be short-lived.

AUD/USD 1-minute Chart: November 28, 2011

Charts created using Strategy Trader– Prepared by Christopher Vecchio

Still, even as the 3-month EUR/USD basis swap deteriorated to its worst reading since October 2008 – a sign that there is exceptionally high U.S. Dollar demand among Euro-zone banks – markets caught bids and surged significantly higher. The Australian Dollar led the commodity currency block, posting a 2.56 percent gain against the U.S. Dollar, at the time this report was written. Overall, the FX Carry Trade Index – an equal-weighted basket of long-Aussie, Canadian Dollar and New Zealand Dollar positions against short-Japanese Yen, Swiss Franc and U.S. Dollar positions – was up by 1.86 percent, at the time this report was written.

Where did this rally come from? In part, it is likely due to short-covering as markets were exceptionally bearish; the long-U.S. Dollar trade against the Euro and other risk-correlated assets was very crowded and needed to thin out to boost downside potential. Still, two rumors from the overnight were the catalysts for the rally. First, the International Monetary Fund was rumored to have been in talks with Italy to provide the indebted nation with up to €600 billion in financing; this was since officially denied. Simply put, the IMF can’t support this kind of loan; there’s little reason to comment on this besides saying the math doesn’t add up. Second, later on in the overnight, there was a rumor that the core Euro-zone was discussing issuing joint ‘Elite’ bonds; German officials have denied this as well. Keeping these in mind, with a Euro-zone finance minister meeting scheduled for this week, we’ll be watching the headlines closely to ascertain whether or not this is just a technical bounce from oversold levels or a bullish reversal is in place.

24-Hour Price Action

Key Levels: 13:50 GMT

Thus far, on Monday, the Dow Jones FXCM Dollar Index is much lower, trading at 9955.06, at the time this report was written, after opening at 10011.62. The index has traded mostly lower, with the high at 10021.17 and the low at 9947.82.

--- Written by Christopher Vecchio, Currency Analyst

To contact Christopher Vecchio, e-mail cvecchio@dailyfx.com.

Follow him on Twitter at @CVecchioFX

To be added to Christopher’s e-mail distribution list, send an e-mail with subject line "Distribution List" to cvecchio@dailyfx.com.