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The currency market has been acting as the adjustment factor between countries positioned at different parts of the economic cycle clock. It has been one of the few assets on which carrying long volatility positions has not been a constant pain. It has also led to a dramatic reversal in the correlation regime, leading to some significant discounts on equity options contingent to currency levels.
Adding longs in EUR rates vol with positive vol roll-down: Equities are demonstrating late-cycle behavior, and a sharp drop in risky asset prices combined with a flight to high-quality sovereign bonds would amount to a double hit on insurers and pension funds’ balance sheets. Positive vol roll down finances a significant part of the theta on this hedge.
We believe there is an elephant in the room that market participants are struggling to see, despite it having huge implications for equity markets. It is the EURUSD impact on US and Eurozone equities. Traditionally, a stronger euro is said to be a drag for Eurozone equities, and in particular core country indexes (e.g. DAX and CAC), and symmetrically a stronger dollar is said to be a drag for US exporters and hence US equities.
But the US and Eurozone equities are also strongly positively correlated. How can this correlation matrix work? In fact, it is the relative performance between US and Eurozone equities that is generally driven by the EURUSD rather than the outright equity performance. Hence a higher euro, despite being negatively correlated with US equity (in a log return correlation), can still coincide with higher US equities.
In the US: The Federal Reserve is no longer expected to pause the rate hike cycle early next year for two main reasons. First, the nomination of Governor Powell as the next Fed chair, in our view, represents a vote for continuity of policy. Second, the unemployment rate is falling again. At 4.1 percent, the risk of a substantial undershoot is rising, as a result, the dollar remains cheap to rates, and this gap could close on the passage of tax reform or the Fed’s insertion of another dot next week.
