FX Strategy going forward

NFPs were stronger-than-expected, but by no means fantastic at 175k, just below the mean (188k) for the last year. The ECB came out, not concerned about EUR strength, and while not hawkish, just less dovish. With the STIR future still implying a yield of less than 0.5% out to December 2015, there is not really a chance for the rate path to be pushed out in time.

(This being said, the BIS had a nice chart in the quarterly survey suggesting rate paths as per Central bank projections are pretty rubbish, and if they can't get it right... who knows?)

Black - Actual, dotted lines = expected.

Going forward: looking at EUR forward swaps, there is honestly little room lower. the 3 month rate 1 year forward is at a mere 0.34%, and the USD equivalent at merely 0.44%. I see the short end of the yield curve being the main driver in G10 FX (ex JPY and AUD vis a vis the USD) for the foreseeable future, and as such, short end forwards give me a good guide as to current yield differentials and where they see monetary policy going in the next 12 months. Even though Eurodollars see hikes >1y away, there is still a clear and present divergence between monetary policy. This being said, in the shorter term as can be here, the possibility for a month through 1.40 and to 1.42 is quite likely. Longer term though, I see a reversion to historical relationships that we've seen (such as 2Y sov spread).

For now though, the EURUSD will be most sensitive to the very short end (3M OIS spreads etc) and as such I don't expect any serious downside for a longer period of time. >6M away.

1y forward 3 month swaps top pane, spread in red, EURUSD in green

As such, when the time comes that US data, and importantly data surprises start to pick up, I expect to see the EURUSD trade more akin to the spread (as seen above), but that is a while off, with meh NFPs and the .CESIUSD dropping like a stone (because the weather... right?)

CitiFX economic surprise index for the USA

Overall, still bearish USTs and happy to add shorts on the belly of the curve, but cautious on USD - there won't be any strength unless we see a significant pick up, its not like the ECB can do anything to weaken the EUR (if they even want too!), even a rate cut wouldn't do much. I think it would require QE...

RBNZ and the NZD: It is no secret the RBNZ don't like the height of the NZD. its the strongest currency YTD (+2.95 vis a vis the USD). Trading at 0.85, its definitely elavated, and importantly the current implied yield on a 1Y forward is about 3.21%, far above the 2.5% or so base rate spread. So basically the swaps market sees hikes, and plenty of them... in fact by my crappy calculation and composite chart I made I get about 123bps worth of hikes in the next 12 months.

Red (filled) RBNZ exp., RBA in white, Blue is spread, AUDNZD in red

 As we can, 123bps is priced in, and we can only assume that is in the NZD FX rate too... Where as the RBA expects about 1 hike in next 12 months, with rates expected 40bps higher next year.

All in all, I think there will be less than 125 bps of hikes in NZ and more than 40bps of hikes in Aus. So, one can only deduce in terms of FX exposure, being Long AUDNZD (and short NZDUSD in due time). Reason for the lack of hikes comes from my friends blog Here and many others, notably FX rate impact, "slowing" in some impactful EM, and Australia not much worse than NZ at all.

But broadly, I've made a point of downside vol in AUDNZD being too expensive given the pricing of rate hikes in the market, and I still firmly believe this however since posting it here, the risk reversal skew has come off a lot, with the 3M smile looking almost symmetrical.

GBP and why I see limited upside: I've summarized these points, multiple times recently on twitter, but here are my thoughts in one place.

1.) Forward rates, and spot rates have reached a ceiling, GBP 1y1y at 1.3%, GBP 1Y forward implied yield at 0.34%.

GBP vs 1Y implied yield, 1y1y on bottom

2.) Growing CA deficit - quite simple, likely to weigh on GBP over time, therefore medium term, I can't get too constructive GBPUSD

One worrying thing long term for GBP is the CA deficit. Just look at our neighbours on this... pic.twitter.com/7275fcAoJL
— Jere Wilkinson-Smith (@JeremyWS) January 21, 2014

'Nuff said on CA

3.) Positioning in the market - As per BNP Ps FX positioning indicator GBP is most longed. At threat of weak longs capitulating at the first sign of dovishness from BoE, or loss of momentum in UK macro. On the latter, PMIs very strong, hard to sustain that level, likely drift lower into 55's and could weigh.

BNP Paribas FX positioning - still heafty GBP longs, CHF flipped from short to long, growing CAD shorts too. pic.twitter.com/54zYHUFiNH
— Jere Wilkinson-Smith (@JeremyWS) February 27, 2014

I usually look at risk reversal as my positioning indicator, in fact my GBP fair value model is simply Risk reversals and interest rates, It has worked *very* well.

On top of this, IV has been very suppressed, and in fact the market seems short Vol, leading to an overall short gamma position. Thus if the newsflow is quiet, the hedging could dominate short term flow and a move lower will be pinned down by sellers of small rallies. Obviously the vice versa is true, with rallies being supported by dips buyers well.

4.) Techs, see previous post here - timing not fantastic, but added shorts and so avg, is 1.67 or so. More rationale behind GBP short there.


Either way - these are my thoughts going forward, hope you enjoyed. Thanks.

(originally planned on some EM, but getting late and school in the morning)

EUR vol too low?

Volatility has been on a downward path for years, and given the persistent weakness in the USD, its no surprise that implied vols are low.

Today we saw 1 month implied vols leg lower into the 5 handle with spot pushing higher through 1.3750, this level of IV has not been seen since mid 2007, however it does seem to have found a floor at around 6%

EUR 1 month ATM IV

Here is a bigger picture, this time with the 3 month Implied Vol, and 60D realized vol (red), both have been storming lower.

EUR 3M IV and 60D realized vol

While we have been firmly below the historic mean for volatility, I think that is about to change. The EURUSD has been stubbornly strong built from a strong, and growing, current account surplus. This being said, even with the bullish factors, there are a multitude of bearish ones, one of which is the diverging monetary policy which should play out eventually - at least when the market moves to pricing from the forward rate spreads as opposed to spot yields (Here)

Now looking at the technical picture we can see the EURUSD is at very critical crossroads. Teetering on the edge of a potentially explosive break higher (and through 1.40, maybe even 1.42)

EUR daily chart, with implied yields in red

While there may not be a clear fundamental reason for a break higher (slowing US?, un-taper?, EZ inflows?) the clear technical picture shows the potential breakout from a >5y trendline from the all time highs. 

Conversely, if we have short end US rates picking up further, the EUR will likely fail to hold the mid 30's and topple over towards 1.28/1.31. 

Where the trade idea comes from is that I see it unlikely that in 3 or 6 months out we will be in the same situation. To me, its pretty binary - we break higher, or we topple lower... Both will be of sizeable magnitude as the importance of the current trendline can not be forgotten.

So this is where it links to the volatility aspect - I can't be sure which way we go from here (my bias is to the downside), but what I am confident is that we will finally see a definitive direction to the EURUSD.

When looking at the vol term structure, we see that, across the curve, Implied vol is very low - but its almost flat out too around 6 months

EUR ATM vol term structure

EUR vol surface

The vol surface somewhat backs up the idea of looking at a purely vol based trade and having no directionality, as we can see there is no significant skew in the smile at the short end of the vol curve - that is to say, puts and calls are of similar expense.

As such, given the above points, positioning "long vol" seems sensible to me. Structured simply via buying a 3 month ATM straddle.

EUR 3M straddle calculator

As we can see from this, the market needs to move about 350 pips either side of 1.3750 to be in profit at expiration in its most simplest form, but also the vega/theta is around 27 days, so if we see a move higher in IV then the trade should profit also. N.B. probs will delta hedge based on short term movements to get the most out of it.

Bonus chart - EUR is starting to move to away from my short term fair value model

Selling GBP against the highs

We've seen the GBP rally over the last few sessions by about 400 points (2.5%) and as we stand at 1.6650 I'm selling at market. This trade is looking for a potential double top at 1.6660 or so, where today, we failed to meaningfully take. Trading on the periphery of a large stops, means the probability may not be as favourable as potentially waiting for the GBPUSD to topple over, but vastly increases the risk:reward profile of the trade.

GBPUSD 4 hour chart w/ stochastics

Furthermore we can see that the market is appearing to be overextended in the short term with stochastics in the low 90's - this is on top of an impressive rally over the past week with the GBPUSD rallying for the 7th straight day, last time it lasted for 8 was over 160 weeks ago. While not itself a reason to sell, the market is running out of momentum (see stochastics) and we are likely to see longs cover after failing to take the 1.67 level.

On top of selling spot, I'm also selling a 1.70 March 6th call for 22 pips premium (mid vol 8%) at spot ref 1.665. Assuming we do roll over tomorrow, at 1.6550 I will look to sell 1.61 puts for the same expiration so as to structure a 3-week strangle, with net premium in around 34 pips. The Vega/Theta for this expiration is around 7 days, so It would be good if implied volatility stays low, but overall this should not be a problem.

First target is down at 1.65, but Ideally, I would like to hold down towards 1.6250

On a side note - today is the first day in a long time where the EURUSD has risen yet my short term fair value model for the EURUSD has fallen, very strange...

ECB and NFP

*ECB LEAVES BENCMARK REFINANCING RATE UNCHANGED AT 0.25PCT
*ECB LEAVES INTEREST RATE ON DEPOSIT FACILITY AT 0.0PCT

The two main headlines to cross the wires at 12:45GMT today. While not a surprise at all, the market reaction was a little mixed. A quick EUR bid, before turning lower ahead of the press conference.

EUR tick

In this time, the DAX had a bit of fun, flash crashing 2% on the front month Futures contract as shown below, while also taking about 30 points from the EURUSD

DAX futures

Then came the Press conference with Draghi, while honestly there is not much new added, it did have a mildly hawkish sense to it. On this, unsurprisingly EUR rate markets where quite active with 1y1y EONIA forwards trading up a couple of basis points. EUR 1 swaps traded fro about 11 down to 3 at one point, cutting the implied yield from 8bps to 4bps, as seen here. The improved EUR rates pushed down the yield differential and pushed up the EUR spot price.

EUR 1 year implied yield (USD - EUR rate)

It has been relatively boring since the press conference, trading very flat around 1.36 EURUSD and 138.5 EURJPY

And as we can see, the EUR lagged the rates post ECB rate decision, as such it was not that much surprise to see a firm bid under the EURUSD, but after the headlines the modelled Rates to EURUSD tracked perfectly. (model based on rate differentials and volatility skews).

EUR vs rate model and spread in bottom pane

BUT, as we can see from the ECB nominal liquidity action is almost certainly needed to avoid short term money market rates from spiking higher, and so there is still potential for the ECB to act in some way or another and remain on a dovish path.

ECB nominal Liquidity

Now looking forward, tomorrow we have the NFP, arguably the most important scheduled data release, and so it is good to see what the market expects of this. What we can see is an expected print of 182-185 based on the median/mean for the Reuters poll.

NFP poll

Some select names see NFP coming in at - 

Barclays - 175K

BNP Paribas - 185K

commerzbank - 200K

Credit suisse - 195K

Deutsche Bank - 200K

Goldman - 200K

Morgan Stanley - 215K

Nordea - 150K

Soc Gen - 290K

What we can see from the options markets currently is the O/N Implied vol in the USDJPY is currently Mid around 19.6, with EURUSD mid around 12.

Pricing this up, as it stands now the Market breakevens at spot +/- 82 pips for USDJPY as seen here.

USDJPY ATM straddle B/E

This means that the market sees about 101 to the downside on a "miss" and about 102.60 on the upside with a strong beat in NFPs

Some other FX ATM breakevens 

AUDUSD - 80 pips (spot 0.8975)

EURUSD - 76 pips (spot 1.3600

USDTRY - 210 pips (spot 2.2070)

So there is definitely some decent expectation going into tomorrow, but as we seen with recent US data, the weather has played a key part in recent data pieces and the Jan NFP will likely be no exception. But bear in mind, given the last NFP reading and subsequent FOMC action, it would appear a major (negative) print would be required for any serious "taper-off" talks.

Emerging Markets - 29/01/2014

So the CBRT had an emergency meeting where the following headline came through

*TURKEY'S CENTRAL BANK RAISES OVERNIGHT LENDING RATE TO 12.00%

*TURKEY'S CENTRAL BANK RAISES BENCHMARK REPO RATE TO 10.00%

So Turkey raised rates quite considerably and a full list can be seen here

CBRT rate hikes, HSBC

As expected the TRY caught quite a substantial bid, moving from 2.25 to around 2.15, not too bad. However there was one overarching problem with this, the substantial rate hike which accounted to about 225bps would severely damage the macroeconomic picture. That is on top of an already slowing economy so it really won't end well, but they had little choice... FX reserves are under $40bn and trying to talk the TRY higher failed many times.

So what what remembered was that this was the CBRT's last move, they couldn't realistically put rates up again, and couldn't really intervene directly. As such the TRY really struggled giving back all the days gains to trade back towards pre-CBRT levels

USDTRY 2 day tick

The market somewhat settled down, with USDTRY trading around 2.24 (stopping out HSBC after just 12 hours)

@UlasAkincilar @katie_martin_FX pic.twitter.com/JvLjhDhVKr stop was 2.24, now price touched that some places(on reuters), others came very clos
— Jeremy W-Smith (@JeremyWS) January 29, 2014

At this point the days move was already incredible, but what came next was utterly ridiculous.

*SOUTH AFRICA RAISES BENCHMARK RATE TO 5.50% FROM 5.00%

The market was a tad surprised to say the least with 25 of 25 economists expecting no rate hike. This however (much like BoE in 1992) made traders interpret the recent hikes as weakness on the part of both ZAR and TRY which both immediately started to tank.

USDZAR

The USDZAR reversed the initial spike lower on higher rates and proceeded to move 3% upwards, and over 4.5% from the days low (post CBRT)

This fear spread to all the asset classes and quickly we saw the USDTRY trade up to 2.32, causing risk off across the market, ES dropped, Bond were bid, JPY was bid etc etc.

ES white, TRYUSD yellow

However, more concerning was the contagion that spread in EMFX where the RUB weakened to 5 year lows vs. the USD and all time lows vs. the EUR

USDRUB 5yr

Not just RUB, but even the stronger (CA surplus EMs) ccy's sold off with the HUF down 1.5% vs. the EUR and PLN down 0.5%

All things considered, I really don't see this action today being a solution to the problem, it won't fix the structural deficit for turkey, it won't encourage Speculators to buy TRY (and could like with BoE 1992, cause the market to test the central bank and destroy the ccy) and finally it will hurt the macroeconomic picture for TRY.

In summary, today was the largest ranged day for over 5 years with around 7% from high to low, based on spot. It also pushed the 1 month IV to its highest since 2009

USDTRY range

TRY 1 month Implied Vol

Best part is, the FOMC haven't even annouced their plans yet, which will likely involve a $10bn taper, which could worsen the situation for EM FX even more.

Forward Rates

Since the beginning of 2014 there has been a significance divergence in some of the forward rates for major currencies. This should be a key factor going forward for the FX markets as the guidance and expectation from Central banks should be a critical factor.

Below shows some 1y rate 1y forwards

1Y1Y rates for GBP, USD, EUR, CAD

As we can see here, CAD 1Y1Y rates have dropped by around 25bps, EUR rates down by 8 or so. Yet USD and GBP forward rates have risen marginally.

This divergence will be very important when looking to the medium term, as we can the fixed income markets start to react and so far, in FX, only the CAD has responded to the changes in central bank outlooks.

Since the taper though, the market has moved to from a state where it was considering the (at the time) present factors, and instead has moved to considering how these are going to change over the next 1/3/6/13 months etc.

This point can be illustrated by simply looking at the EURGBP, right off the bat there should be no obvious implications of a Fed Taper, there is no excess correlation with the USD between either of the EUR or GBP and as such it should have been a neutral event. But it wasn't.

EURGBP hourly

As we can below - the EURGBP has traded mostly in tandem with 1Y implied yields (from forwards) for the most part of the last 5 years. But these 1Y rates on show the current picture, when looking ahead now, we need to consider how they rates are going to change.

EURGBP 1Y implied yield vs EURGBP

That is why, since the Fed Taper - and pretty much since it became an idea in the early part of 2013, the EURGBP has been trading much closer to that of the 1Y1Y spread. (shown below)

1Y1Y spread vs EURGBP (red) and 50 day correlation

We can see the correlation moved from mixed to decisively red, where red shows a negative correlation (because the spread is inverted on the right axis)

As we can see that now looking at 1Y1Y rates are far more important than just 1Y rates as now investors are caring much more about the central bank path than pre-taper.

The reason why the taper is so important is it has acted as a psychological change from "uber-dovish" to "cautiously hawkish" and this means that the markets will start to consider the fact that base rates will soon be on the rise (as opposed to the idea that we've ZIRP ad infinitum).

Now in the case of the EURGBP the central bank divergence is pretty obvious - ECB have recently cut rates and will have to ease more, where as the day-by-day pressure on the BoE to hike is increasing (consider U/E recently). As such selling rallies in EURGBP should be good all year.

Another example is AUDNZD.

Here is a chart of the AUDNZD spot, AU-NZ 2 year spread, and the spread between the 2 year rate 1 year forward.

AUDNZD vs rates

Once again, since mid 2013, the AUDNZD has become far more correlated with the forward rate spread as opposed to the current spread. The divergence between the RBA and RBNZ is quite clear, but relatively minimal in comparison to others.

So, looking forward, using the idea that the market will start, albeit slowly, to noticing forward rates more and more the EURUSD looks to be a good sell going forward. So long as the rates factor becomes more important than the relative balance sheet and also the strong Current account position of the EZ.

But providing it does, the EURUSD will come under heavy pressure as the expectations widen more and more, and the yield spread widens to a point where the EURUSD can no longer justly trade at these levels.

Finally it would be easier to just pay USD rates and recieve EUR rates but it should filter through to the FX markets.

And here where the current implied yield is in Blue as well, we can see how it is very much like EURGBP pre 2013 where it only cared about now, as opposed to the future.

This is could be what we are looking at if the EURUSD starts to price in the future as opposed to the present. (ok maybe not 1.20, but under 1.30)

AUDNZD downside vol too expensive

Firstly, the AUDNZD has been very, very weak over the past year, unsurprisingly to a point, but now it seems a little extreme to me.

Below we can see the AUDNZD plotted against the AU 2 - NZ 2 year yield spread, and an accompanying model (AUDNZD=Bid,0= 1.202 + 0.1465 x (AU2YT=RRBid Yield,0-NZ2YT=RRBid Yield,0)) to show the divergence when related to price.

AUDNZD, rate spread (red) and model (purple)

Right now, with spot trading 1.07, we are clearly below where the rate spread would otherwise see us trade. over the course of the year the AUDNZD and rate spread has an R^2 of 85% suggesting that the theory the related FX to rates held strongly.

However right now, with the 2 year spread at 41 bps this prices in the AUDNZD at ~1.14 (+/- 1.5%), but it is clearly outside of this range by quite a lot. But when using this relationship to see why we are trading where we are, we see that the AUDNZD is pricing in a rate spread close to 100bps (more precisely 90bps +/-8), more than 50bps wider than current.

AUDNZD model with 90 bps and 125bps 2 year spreads as question

As we can see here, at 90 bps the model expects the AUDNZD to be trading at 1.0702 (pretty much spot)

Which in essence given the relative similarity of the AUD and NZD yield curves (in terms of shape) and given their equal base rates, means that the AUDNZD is trading currently with ~50 bps of RBNZ rate hikes built in. With the RBNZ unlikely to raise rates 50 bps in the coming 6 months then we have some potential opportunities. First comes from the idea, that if the RBNZ puts of the inevitable rates hikes a little longer, then Spot should, over time move towards the rate fair value in which case buying spot at 1.07 would be a good idea, and even if the RBNZ does hike, it currently prices in 50bps as we trade now so there is a clear buffer.

RBNZ OCR rate path

Furthermore though, when we consider the volatility smile for AUDNZD we can build some ideas.

1M, 3M, 6M vol smiles

We can see that, somewhat unsurprisingly there is a higher IV for puts vs. calls. And this would make sense in the 1Y duration as that is most likely when the rate spread between AU and NZ is at its widest. Above in the calculation, 125bps is put in to the calculation and returns a value of 1.02 for AUDNZD. So a move towards parity is technically possible, but for now, a long way off.

But for now, when considering the 6M duration, the 10 delta put is trading at 8.21 (mid) and the strike on the 10D put is around 1.01

AUDNZD and 10 delta 6M strikes

So we can see that the 10D strike is 1.01, and given that the market is already pricing in 50bps of hikes, it is unlikely that in 6M that it could trade 600 points lower and price in another 35-40 bps of hikes. And therefore, based on the level of IV and the probability that it manages to trade that low, it would make sense to consider selling these puts naked. The heightened level of IV for the puts on the short term makes this trade, at least from a risk:reward standing very attractive to me.

A way to increase the premium (and in turn, the amount you receive by selling) would be by also selling the 10D calls with a strike of 1.16. AUDNZD is unlikely to recover that far in 6m due to similarity in the RBA and RBNZ rate paths.

So entering a 6M 10D strangle would receive approx. 57 pips or just over 0.5%, not huge, but when factoring in the probability of a move outside of those bands in 6M it is a very strong chance this trade will perform.

conversely you could increase the delta ( bring the strikes closer to ATM) and hope to receive more in premium and you would, but also decrease the probability quite substantially that the AUDNZD trades outside the band. For a 20 delta 6M strangle you receive around 129 pips (1.25%) but the strikes are 1.03 and 1.13.

But like I said, this isn't about being in a strangle as much as it is about the downside puts being far too expensive up to 6 months, based on the idea that the AUDNZD is unlikely to move to a situation where it prices in a 125bps differential on the 2yr.