In the recent past, the trade protectionism theme shot back into focus as a potential major left tail risk for markets. FX vols climbed more than 1.5pts on VXY-EM basket and 1-vol pts on VXY-G10 within a week. The sharp vol rally eliminated the extreme cheapness of the EM basket, lifting the VXY-EM off the July multi-year low.
Nevertheless, VXY-G10 is only back to the year start levels and on our workhorse cyclical framework, which takes into account the trajectory and surprises in Global PMIs and ex-ante forecast uncertainty surrounding key macroeconomic variables, FX vols are now off the 2-sigma undershoot but remain 2pts cheap on macro valuations even after the recent move (refer above chart).
While the expectation of the US-China trade turmoil likely to continue to ratchet-up rather than to de-escalate, and our Asian FX Strategists now target USDCNY to reach 7.35 by year-end. Combined with lower targets for EM FX as well as EUR, the broad dollar is now expected to grind 1.8% higher to within a percent of Dec-2016 cycle highs. Recent events confirm that we have entered a collective global policy easing cycle.
During such environment, establishing a pecking order of easing is important to determine FX out- and under-performers, but a look at past collective global easing cycles also highlights USD outperformance. This further underscores that the start of Fed easing does not always portend a dollar downtrend.
Sterling bulls seem to be prepared to clutch at any straw possible at present. The British currency was able to appreciate against the euro and the US dollar yesterday. The reason behind this was a report according to which some British MPs are hatching plans to prevent the UK from leaving the EU without a deal in October.
Prime Minister Boris Johnson would simply plan to set the date for early elections for a time after the Brexit deadline on 31st October. As there is still no plan for preventing a no-deal Brexit, Sterling is keeping up surprisingly well in my view. Admittedly, the British currency has already depreciated by approx. 10% against the euro since May.
Euro is being the beneficiary of the current market environment. Fears of a global recession have caused a flight into safe havens, and amongst them is the euro - even if it might benefit to a lesser degree than the more popular safe havens like the Swiss franc, Japanese yen, and US dollar. In principle, the single currency is nonetheless appreciating, as a glance at the trade-weighted euro exchange rate is illustrating. In addition, BTP spreads have widened but in view of the rally on the bonds markets, even Italian yields are at such low levels that fiscal concerns are not really justified from the market’s point of view - a stroke of luck for the euro.
Global easing cycles have also historically coincided with a rise in global tensions over macro policy and spill-over effects, usually transmitted through currencies, and generally termed “currency wars”. This week we categorize “currency warriors” from “non-combatants” across currencies.
The recent moves halved the FX vol undershoot but with the bubbling trade developments, our bias remains long.
Own vega on the weak side of the CNH riskies for long vol exposure but at smaller decay cost. Alternatively, finance it with short downside front as realized vol is under watchful PBoC hand. Wide 10D – 25D USDCNH call skew poses an opportunity for constructing low cost and high leverage 2M USDCNH topside structures.
Consider long vega exposure via cheap -6M6M / +1Y6M FVA 1*2 spreads in CADJPY and 3M risk-off call spreads / digitals in JPYKRW and AUDJPY for hedging the simmering broad-based risk. Courtesy: JPM