The euro hit a six-week high against a broadly weaker dollar on Thursday with doubts creeping in as to whether pent-up demand for the U.S. currency over the year-end will be as strong as previously thought.

Implied interest rate spreads also moved in the euro’s favor after European Central Bank Executive Board member Juergen Stark said late on Wednesday the bank did not have a lot of room for manoeuvre on rates after its cut last week.

Having climbed on a wave of risk aversion in recent months in tandem with the low-yielding Japanese yen, some analysts said further dollar demand into the year-end from deleveraging flows might be showing some sign of cooling. A fall in volatility also indicated that extreme risk aversion may be easing.

“We’re seeing some year-end position adjustment. With volatility coming down, it may prompt some investors to dabble in risk,” said Geoffrey Yu, strategist at UBS in London.

By 1150 GMT, the euro was up 1.1 percent on the day at $1.3171, having hit a six-week high of $1.3186 earlier in the session.

Implied volatility on one-month dollar/yen currency options fell below 20 percent on Thursday compared with that level seen at the start of the week .

The single currency spiked late on Wednesday after the Stark comments, while implied euro/U.S. rate spreads reflected a cooling in ECB rate cut expectations. By contrast, the U.S. Federal Reserve is expected to cut borrowing costs again next week.

“If the euro zone is being perceived to still have rates at substantially higher levels then obviously there’s a positive rate spread, but I’m not convinced that its ultimately going to be positive as the dynamics of the euro zone economy are pretty weak,” Rabobank markets strategist Jeremy Stretch said.

Against a basket of currencies, the dollar was down 1.0 percent at 84.604, while it also dipped 0.4 percent versus the yen to 92.18 yen .

The Swiss National Bank became the latest leading central bank to cut interest rates, but its impact was limited as the 50 basis point move paled in comparison with more dramatic reductions from other central banks last week.

The dollar traded up at 1.1927 Swiss francs compared with 1.1905 francs just before the SNB rate decision, and the euro rose to 1.5713 francs from 1.5625 francs .

CRACKS IN GLOBAL PLAN?

There was little reaction in FX markets to the approval of a $14 billion auto industry bailout plan by the U.S. House of Representatives.

While the House stuck to its plan, uncertainty was seen in the Senate, where a razor-thin Democratic majority cannot ensure passage. A vote could come as early as Thursday, but some Republicans have vowed to slow or even block the legislation.

Elsewhere, cracks were appearing in the global effort to drag the world out of recession on Thursday with Germany attacking Britain ahead of an EU summit for rushing into debt to bail out industries and pump up growth.

In an interview with Newsweek magazine, Finance Minister Peer Steinbrueck urged governments to pause before pledging to spend billions of dollars to try to push their economies out of trouble.

By Tamawa Desai

LONDON, Dec 11 (Reuters)

Investors will be utterly confused today about what to fear most. First, you had the nightmare open in New York on Friday. The futures markets were limit down and closed briefly. By the time order was restored to electronic markets, the Dow opened down 6%.

The Dow rallied-if you can call it that-to close down “just” 3.6% on the day. A that point, you could safely say the market was ‘pricing in’ the fear of a global recession, and just what that would mean for corporate earnings. Not even an oil price of US$65-meaning lower prices at the pump-could cheer investors.

And then, this weekend, European and Asian leaders met and, “pledged to undertake effective and comprehensive reform of the international monetary and financial systems,” according to Bloomberg. China’s Premier summed up the argument for the 40 heads of state present by saying, “we need even more financial regulation to ensure financial safety.”

And thus a great debate unfolds in the weeks ahead of the November 15th G20 summit in Washington. Was the crisis a result of unregulated “cowboy capitalism”? Or did it have its roots in phony, government-regulated interest rates, which skewed corporate and personal incentives in favour of debt-based speculation? More that in a moment.

Did you see news reports that the RBA intervened in the currency markets? The Bank is trying to prevent the Aussie dollar from going “splat!” Truly, there are few currencies in the world that have fallen so much, so quickly. But why?

Chatting with Swarm Trader Gabriel Andre this morning, he said the seven-year up-trend in the Aussie-Yen currency pair has been completely reversed in the last three months. Kris Sayce will be running Gabriel’s comments in today’s Money Morning. What does it mean?

The currency pair is as good a symbol as any for what fuelled the global rise in speculation. You could borrow virtually for free in yen and invest in high-yielding currencies and assets. Those assets included Aussie stocks and the Aussie currency itself. The collapse of the yen and dollar carry trades is what’s behind the plummeting Aussie dollar.

Meanwhile, the government still hasn’t fixed the problem that’s mushrooming in the cash and mortgage fund market. Over $11 billion is still frozen in those accounts as the firms that run them try to work out a deal with the government. But what deal could there really be?

Investments in mortgage funds are not deposits in banks. By guaranteeing bank deposits, the government drew attention to the fact that investments always have risks, and that some risks cannot be insured against. You either take them and accept the risk (in exchange for the return), or you keep your cash in a safer, but lower-yielding security (or in cash, subject to inflation).

It would be nice if you could get a guarantee in life that you’d never lose money no matter what kind of decision you made. But no such guarantee exists. It just happens that we live in an age where no one expects to lose at anything, ever. This goes for kid’s soccer games as well as financial markets. But if there aren’t real winners and losers, you don’t have a real market.

Congratulations to our friends at www.businessspectator.com.au. The financial news and analysis site is turning one year old this week. It’s a precocious one-year old, though. And there is a lot of collected wisdom there.

For instance, Robert Gottliebsen recently made this chilling observation about the hedge fund meltdown, “The mortgage fund freeze has escalated the number of superannuation investors who are demanding to exit the managed fund equity system. At the moment it is containable but if the move to quit shares balloons we will see big forced selling of Australian stocks.”

Hopefully the mortgage freeze will end soon. Perpetual says this morning that it would like to end its freeze on redemptions as soon as possible. Exactly when that is is anybody’s guess.

As if the credit crunch and a global recession weren’t bad enough, investor now have to deal with calls by the Europeans and Asians for Bretton Woods two. Everyone wants a new global financial system. But it’s not like buying a new shower head or toilet seat, is it? You can’t just run down to the shops and get one, along with some beef jerky.

It’s obvious the current system is breaking down. Globalisation-made possible by cheap money and cheap energy-is contracting. You know for certain that governments, being blame artists, will blame markets. But it’s not the market’s fault. As with every bubble, from Tulips to the South Seas to the Mississippi Scheme, it’s people who pervert markets.

Sure, CEOs and corporations turned normal businesses into vehicles for private speculation. But that is a failure of management, not the market. More oversight by corporate boards and shareholders might have made for better discipline in risk taking. But discipline is exactly what people lose in a bubble.

The credit bubble was remarkable because it leveraged the interconnectedness of global markets, allowing investors to borrow in weak currencies and invest in high-risk, high-yield assets. It wasn’t a regional or even national bubble. It was the whole planet.

But in its other essential features, it is indistinguishable from previous bubbles, manias, panics, and crashes. One of those features in fact, is how governments and bad regulations actually enlarge, prolong, and generally abet the bubble. And in this one, because everyone had a stake in its expansion, everyone has tried to keep it going. The best example of this is the determined allegiance to the dollar-pegged world financial system.

The price of money is fixed by central banks via interest rates. For years, everyone followed the Fed’s lead in the U.S. and set the price of money below rate of consumer price inflation. Australian mined. China produced. Europe traded. OPEC pumped. The U.S. spent.

Global bubbles in all asset classes ensued. That is a failure of the highest order by the regulators of global interest rates. Now politicians see massive wealth destruction and blame free markets for screwing things up when it was the non-market price of money that touched off the crisis to begin with.

In any event, we’re going to get some sort of hogwash in the next month from the confab in DC. There will be more supervision of banks. It will probably lead to less bank lending and tighter credit. Hedge funds will be regulated. Many investors will anticipate this by taking their money out ahead of time. Redemptions will force more asset sales. Stocks will fall.

The International Monetary Fund will probably enjoy some enhanced status. The IMF is already bailing out a bankrupt Iceland. It will loan US$16.5 billion to Ukraine. Before it’s all over, we reckon Japan and China might even consent to loaning some of their huge dollar reserves to the IMF in exchange…for something.

We’re not sure what it would be yet. The IMF may become a super-bank with access to funding from central banks, a kind of supra-sovereign wealth fund in the service of a world government and regulation. That sounds…not encouraging.

Also, keep in mind that the entire strain of the crisis in the U.S. was generated by a politically desirable outcome in residential housing. The original mis-allocation of investment dollars came about because politicians insisted that banks make loans to people who couldn’t repay them. Market discipline was actively subverted by political opportunism.

The U.S. set up Fannie Mae (FNM) and Freddie Mac (FRE) with preferential borrowing terms so those two could buy up mortgages originated by the banks. The banks could sell the mortgages quickly, which put them in the position to fund even more mortgages and expand “home ownership” in America.

We all know how that’s working out. Median U.S. house prices continue to fall. The loans made to finance those homes are going bad. The securities made up of bundles of those mortgages are rotting, taking bank capital with them. And insurance sold against default in them is putting the sellers of that insurance into great difficulty.

Europe, for its part, has a brewing problem in emerging market debt. Austrian banks are exposed to sovereign emerging market debt to the tune of 85% of GDP. Swiss banks have emerging market debt equivalent to 50% of GDP. It’s 25% in Sweden, 25% in the U.K., and 23% in Spain. If more emerging markets go the way of Iceland and default on debt or go bankrupt, Europe’s banking system faces major trouble. Just what we needed. More trouble.

Dan Denning
for The Daily Reckoning Australia

Source: Europe Faces Day of Reckoning in Emerging Market Debt