FX Strategy - March 17th

Global Macro / FX strategy

G10 FX Overview:

The USD is still going to be key going forward, with the Dollar index (DXY) perched on the edge of a potentially large breakdown. FX volumes across major ECNs and interbank dealing platforms are still a little low – but we are seeing with the uptick in emerging market volatility a slowly rising level of volume across the G10 spectrum. As it stands, the NZD and JPY are still the best performers YTD vis a vis the USD, with the former up 3.6%. Looking forward it is clear to see that geopolitical risks from the Crimea will play a big part of the overall risk sentiment. EURCHF will be the best at gauging this risk, this being said we will potentially see the SNB firmly reassure the 1.20 floor and as such could change the dynamic of the pair.

In other news, the PBoC raised the trading band for the CNY to 2% from the daily fix (from 1%), this will undoubtedly lead to higher realized volatility in the CNY/CNH markets. Even though short term Implied volatility may appear stretched, it may not drop lower and we could see a permanent (unattractive) shift in the carry/vol aspect of the CNH. If we see spot CNH start to weaken, other Asian CCY’s are at risk (such as KRW or TWD), in this case the SGD could be seen as a local safe haven, on top of the USD and JPY which will act accordingly under the heightened risk. The pain will be felt above 6.20, were corps may have to hedge their short topside calls, which would involve buying spot USDCNH. USDJPY would likely test the very critical 100 level in this case.

G10 Rates Overview:

On the back of the Rate hike from the RBNZ, NZD swap markets will remain interesting. There is still expected to be >100bps of rate hikes in the next 12 months. This idea will be tested with the upcoming NZD GDP number, a significant hit here could see NZD 1Y swaps shed more than 10bps and questions would be asked about the timing of the most recent rate hike.

Other than this, I still have a bearish bias on US treasuries going forward, especially with the US10Y being around 265bps (shorted 1 unit). We saw the yield premium of the US 10’s over the German counterparts reach 115bps last week, and with disinflation/low growth/potential QE in Europe, coupled with potentially faster than expected US macro performance over the coming months I don’t see this spread tightening significantly. As such, I favour selling USTs over bunds in any bond market sell-off. Selling Eurodollar 2015 contracts and buying short sterling of the same expiration offers good relative value, and tracks GBPUSD well.

GBPUSD – starting to top out?

Somewhat surprisingly, the GBPUSD is hardly up YTD (spot 1.6645 when writing), however this is mostly because there has been significant resistance for the GBP to attempt to overcome.  We are trading at the top end of a 5 year trading range, with 1.70 being the critical bull/bear line in the sand. It can be seen that shorts are comfortable building ahead of 1.70, but on the topside of this, it will be a very different scenario. As it is now, the market seems stretched still, with most indications suggesting significant GBP longs. CFTC CoT data shows significant longs, 1M and 3M risk reversals with the 3m tenor only seeing puts trade at a 0.7vol premium to calls, finally Bank positional indicators (BNP P and Citi) show that the GBP is still the most longed Currency among the G10.

Going into this week, we have plenty tier 1 data, with the UK unemployment rate being the most critical for the GBP.  Any downside misses would almost definitely see the weak longs in the market look to cover and we could see the GBP trade south of 1.65. Productivity indictors will also be closely watched and once again downside surprise would really push back the BoE rate path.

GBP vs 1y1y GBP-USD spread

Furthermore, building on previous points, Interest rate spreads – which are very dependent on US and UK data – have seemed to flatten off as has the spot rate. However while tracking well, its starting to diverge.

As we can see, the GBP has closely tracked the 1y1y forward yield spread, but with GBP 1y1y having an apparent ceiling in place (as BoE rate path can’t feasibly come any closer). As such the risks for the forward yield spread come from the USD aspect.

With the US 1y1y trading at 0.68%, I see that the recent bad weather has been priced into the rate market, but given the sturdy NFP, and the almost guaranteed taper, we should see US rates tick upwards with the highs around 0.80 definitely in view. This would imply a 1y1y spread at around 40bps which could see us trade in the low 1.60’s in GBPUSD.

Going forward, taken from the above I expect the upside to be limited in the GBPUSD, most importantly because of the divergence between the cable and rate spreads, but when factoring in the heavy GBP longs the risks are to the downside going into this week’s macro numbers. The claimant count has seen one of the strongest periods of decline in history and maintaining a -20k print will be hard.

Throughout this week, downside support levels can be seen at 1.6540, 1.6474, 1.6275.

Upside resistance can be found at 1.6710, 1.6820 and 1.70.

GBP Spot week implied volatility trades at 6.85 implying a breakeven range of about 126 pips either side of spot. This is historically quite low, but in the short term, most G10 FX vol is very low, and while it can be good to look towards opportunities of buying vol, now is not quite the right time.

GBP 3 month 25 delta risk reversal

I shorted GBPUSD at market (1.6643) at 2x leverage, looking for 1.65, then 1.63, stops above 1.68

USDCAD – dovishness fully priced in?

It is no secret that the new BoC governor (being an ex-export minister) takes kindly to a weak CAD. After all, it will boost their exports, and as so much trade is with the US, the USDCAD is critical to their potential growth plans. Oddly enough, USDCAD is one of the only consensus trades that has performed this year, Ever since Goldman put out their “trade of the year” recommendation to buy USDCAD spot there has been a flurry of sell-side recommendations to short CAD, targeting as far out as 1.18 by year end.

However, a large reason for the bearishness was the relative divergence between the two central banks and their respective plans going forward (figure2). We’ve seen the respective spread between the 2 year government debt tighten from about 90bps in September to around 67bps now (was 60 in Jan). Relatively speaking, the CAD looks quite cheap to rate spreads, and their respective forward paths with spot USDCAD at 1.11.

USDCAD vs 2yr sov spread

Much like the GBP is heavily longed; the CAD is the most shorted currency as per the composite indicator from BNP Paribas, meaning that we could see shorts look to cover if we fail to see further downside in the CAD.

On top of this, traditionally, the CAD is seen as a commodity currency. And historically there has been a very strong correlation with commodity prices; however since the beginning of the year, the CRB index has completely diverged from the USDCAD (figure 3). While commodity prices are starting to look vulnerable across the board, especially considering Copper and Iron prices recently sold off hard.

USDCAD vs CRB (inverted)

However, even though I am constructive on the CAD in the short term, I look to the options market to structure a trade. Given the expected weakness in the CAD, and taking the prior points into consideration, buying puts could be a way to profit from the potential downside while limiting losses. At the same time, the trade would benefit from rising implied volatility by being long vega. However, short USDCAD could work just as well in the short term.

  

EURCHF – SNB will protect the 1.20 floor

Given the recent uncertainty in the Crimea as mentioned in the G10 overview, the CHF has received a moderate safe haven bid. Now, yes Switzerland is running a 10% of GDP current account surplus, which is of benefit to the CHF, yet I do firmly believe the SNB will defend the 1.20 floor. As such, I believe the recent discount the EURCHF is trading at on the back of the Crimea shenanigans to be good timing to look to buy. There are a few options though, I like holding EURCHF as a core position in the medium term. As such, one could position long EURCHF, and if traded via forwards you can receive some yield for holding long EURCHF, you can buy time sensitive upside calls, but the critical aspect is the time aspect (theta decay). With uncertainty around the geopolitical risk, getting the timing right is indeed tricky, finally one could sell downside puts, which are both equivalent  to be long (via delta) and also bring in yield in the form of theta decay.

EUR model

For this reason, I favour the last choice. But either way, the EURCHF looks like decent value at 1.2130, however in the short term, is the EUR the best way to trade potential CHF weakness.

 When modelling the EURUSD vs short term rate spreads, we can see that the EUR is approximately 2% rich to where the fixed income markets would expect to see the EUR. It is true to say that this is merely a two variable regression, but even still there has been a very strong relationship over time and as such the USD can be seen as relatively cheap to the EUR (relative to rate spreads) and maybe it’s best to position via USDCHF as vol will be higher.

I've sold Aug 2014 EURCHF 1.21 puts at 3.5%, delta ~52%

Thanks!