Volatility spikes on announcement of new central bank liquidity facility. Market trying to figure out what this means.

Treacherous market conditions prevail as longer term effects of CB efforts uncertain. Is EURGBP set to break higher?

MAJOR HEADLINES – PREVIOUS SESSION
Overnight developments:

The Fed, ECB, BOE, BOC and SNB announced a variety of measures aimed at injecting further liquidity into the banking system to ease liquidity problems.

New Zealand Oct. Retail Sales fell -0.7% vs. 0.0% expected

UK Nov. RICS House Price Balance fell to -40.6% vs. -28.5% expected

Australia Nov. Employment Change rose 52.6k vs. 20k expected and the Unemployment Rate rose to 4.5% vs. 4.3% expected

China Nov. Industrial Production rose 17.3% vs. 18.0% expected

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THEMES TO WATCH – UPCOMING SESSION

Key event risks today (all times GMT):

Switzerland's SNB gives monetary policy assessment (0830)
UK Dec. CBI Industrial Trends (1100)
US Nov. PPI (1330)
US Nov. Advanced Retail Sales (1330)
Canada Oct. Manufacturing Shipments (1330)
Japan Q4 Tankan Survey (2350)
New Zealand Nov. Non-resident Bond Holdings (0200)
Market Comments

We got plenty of warning yesterday from various sources in the press that something may be cooking within the Fed to further ease the liquidity crisis, despite the disappointing mere 25 bp easing of the Fed disount rate on Tuesday evening. The Fed delivered on these rumors and then some with the dramatic announcement of the liquidity facility in coordination with the major central banks of Europe and the BoC. Essentially these measures (new collateral types, special auctions that de facto lower the discount rate to parity with Fed funds rate, making USD available in Europe, etc...) are intended to unblock the unwillingness among banks for lending to each other as this is what lies at the heart of crisis in credit confidence.

Markets went haywire on the announcement - equities spiked more than 2.5% higher from the lows, only to then fall more than they had risen! The FX market equivalent was a tremendous move in JPY crosses, as EURJPY rose 2% in short order to erase all of the previous day's large losses and then some (though we curiously didn't see a sell-off again like we saw in equities - same goes for US rates, which spiked higher and then held most of their gains... EM currencies saw a similar reaction). The idea of course, is that this liquidity injection attempt can ease the credit crisis and keep the economic expansion party going for another round. The best measure of the effect of this facility, however, is the so called TED spread - the spread between 3-month USD Libor and the yield on US 90-day T-bills. The net effect of yesterday's announcement here? Zero! Watch this spread carefully - as long as it stays this high or even increases, it will continue to reveal desperation among the banks and the chance for any rally for risk willing investments to sustain any sort of rally will be curtailed. JPY crosses are not likely to stay elevated for long. We will have to watch these auctions that the Fed is holding (4 between 17 Dec and 28 Jan) to know what the real impact of this is.

Yesterday, Norges Bank raised rates 25 bps to bring the rate to 5.25%. EURNOK dropped to the 0.382 Fibo retracement of the move from the lows to the 8.150+ highs at 7.9500 area and is at an important inflection point now. Spreads are certainly in favor of a stronger NOK, but the market will likely look to the entire global risk appetite equation to determine the next move now, with NOK at risk again on any bouts of risk aversion. The energy markets are certainly doing their best to give oil currencies a boost with yesterday's huge rally, but USDCAD, for example, actually rose slightly on the day, so oil doesn't seem much of a factor at present.

The UK's RICS House Price Balance for November was absolutely horrible and the accumulating credit situation in the UK and the BOE foot dragging is likely to result in a further demise in housing. The rate differentials continue to suggest that the pound should be getting pounded. EURGBP should be trading much higher now - is it soon ready to jump through that key 0.7255 area to progress to levels not seen in over 10 years (using the DEM equivalent). See the chart below. One has to consider that EURGBP traded up well above 0.8000 in the mid 1990's so current values are not extreme by historical standards. If the market eventually decides that the liquidity facility won't really change the ballgame in terms of risks to the banking sector and growth, then GBPCHF could outperform to the downside (and we expect it to eventually), but the short term uncertainty surrounding the implications of these efforts and the resulting volatility make it a more dangerous trade.

Watch out for the quarterly Tankan survey overnight for JPY volatility implications.

Chart: EURGBP

EURGBP - Is it time for the rally to resume? EURGBP has been biding its time a bit in a range as traders are perhaps reluctant to push it through key technical levels through 0.7255 - levels that haven't been seen since the mid 1990's (using DEM equivalent for the EUR.) The very long-term chart actually looks like one gigantic upside down head and shouders formation with the final "shoulder" actual lasting for more than 4 years. In any case, a break above the 0.7255 level is a key event for this pair if it unfolds as expected.