Euro gets bounce but still vulnerable to contagion risk

LONDON: The euro bounced on Wednesday, gaining a reprieve from this week's sell off, while commodity currencies rose after upbeat Chinese data comforted investors fretting that the euro zone debt crisis could trigger a global slowdown.

But concerns about the crisis spreading to the region's core economies like Italy are likely to keep euro gains in check, with the focus shifting to an emergency summit of European Union leaders expected on Friday.

Moody's cut Ireland's credit rating to junk and warned the country might need a second bailout, echoing recent downgrades to junk status for both Greece and Portugal and serving as a reminder to investors that the euro was vulnerable.

The single currency was up 0.6 percent at $1.4066 , easing slightly from a session high of $1.4111. Traders said it was helped by steady buying from sovereign investors, a narrowing of peripheral euro zone debt spreads over German Bunds and a bout of short covering.

The buying helped it recover from a four-month low around $1.3838 hit on Tuesday. Immediate support is seen around $1.3907, the 200-day moving average, then the recent trough, followed by the March low of $1.3740/50.

"We have moved through the panic phase and seen some stabilisation in Italy which has enabled the euro to make some gains," said Daragh Maher, FX strategist at Credit Agricole.

"But the fact Italy moved into the frame was a game changer for the euro. We might try to push higher short term but then go for another test of yesterday's low. We see the euro at $1.3400 by the end of September."

In the options market, one-month risk reversals were elevated in favour of euro puts -- options to sell the currency. One-month 25-delta risk reversals were at 3.05 vols with plenty of event risks ahead, including the results of stress tests on euro zone banks due out on Friday.

In Asian trade, the euro got some help after data showed solid expansion in the Chinese economy and industrial output, wrong-footing those who had expected a sharper slowdown.

Commodity currencies advanced after the Chinese data, with the Australian dollar gaining 0.7 percent to $1.0673. The New Zealand dollar rose 1 percent to $0.8256.

The euro also rebounded against the Swiss franc rising 0.8 percent to 1.1688 francs, off Tuesday's record low of 1.1555. Against the yen, the euro gained 1.4 percent to 111.59 yen

The yen, which has benefited from safe-haven flows on the back of the euro's woes, hit a four-month peak against the dollar and many other currencies in thin early Asian trade. It gave up those gains as overall risk appetite showed signs of improving.

YEN IN NEW RANGE

The dollar briefly fell to 78.48 yen as stop-loss orders, mainly from Japanese retail traders, were triggered in thin volumes a few hours before Asian trading became active.

Just before that, Japanese margin traders' net foreign currency buying was at a record high, according to data from major margin trading exchange TFX.

The dollar later bounced back to around 79.30 yen, up 0.7 percent on the day, helped by selling from Japanese investors.

Still, the greenback has broken below support around 79.50 yen for the first time since mid-March, when Japanese officials and other major central banks had to intervene to curb the yen, which soared in the wake of the massive March 11 earthquake and subsequent nuclear crisis.

"Intervention is possible given the rhetoric we have had in the past few days," said Simon Derrick head of currency research at Bank of New York Mellon.

"But it will be a wait-and-watch situation as they (the Japanese authorities) recognise that in a risk-averse situation yen-funded carry trades will be unwound. Their intervention will be more to smoothen the move."

For now though, few traders expect intervention.

Firstly, the yen's moves can hardly be described as volatile, with the currency stuck in a narrow trading band in the past few months. In addition, Japanese share prices are holding well above post-quake lows, so Japanese policymakers are likely to be less alarmed than they were in March.

Bank of Japan Governor Masaaki Shirakawa said on Wednesday that policymakers were watching forex moves carefully and a rise in the yen puts downward pressure on the Japanese economy in the short term.

Traders say the dollar is now likely to stay below 80 yen, which is seen as a strong resistance level. Dollar bulls are also wary ahead of Federal Reserve Chairman Ben Bernanke's semi-annual testimony on the economy and monetary policy before the House Financial Services Committee starting at 1400 GMT.

Following last Friday's dismal jobs report, Bernanke could err on the side of caution, adding more pressure to the dollar.

Copyright Reuters, 2011