FxWirePro: FX Options Highlights Amid Macro Backdrop

Growth concerns for both advanced countries and emerging countries have picked up again on the back of a collection of new economic data but also and perhaps more importantly due to continued high uncertainty. The latter stems from escalating tensions between the US and China over trade. The effects of this confrontation already show up in the Chinese data while in the US, mounting anecdotal evidence also points to its detrimental impact on business and the agricultural sector.

Following Chair Powell’s press conference signal that the FOMC was biased to ease this month, incoming news has been comforting. The G-20 Summit delivered a US-China tariff truce and June releases show US employment and core CPI inflation bouncing back from recent weakness. However, this week’s testimony, along with the release of the June minutes, suggests that a July ease was not highly data dependent and the Fed is likely to move by 25bp. 

Chinese data confirm slowdown, the industrial output accelerated from 5.0% YOY in May to 6.3% in June. This was better than consensus had expected (5.2% YOY). However, the output of key industrial goods remained soft. Most notably, electricity output only reversed some of the slowdown in recent months, while production of steel, pig iron, and glass slowed down. While their exports fell by 1.3% YOY in June, in line with consensus expectations at -1.4%, but

down by c2%-points from May. Imports contracted by 7.3% YOY, up from -8.5% in

May, but a smaller improvement than consensus had expected (-4.6%).

The primary motivation Powell gave for easing is insurance, and he noted that despite better news “uncertainties around trade tensions and concerns about the strength of the global economy continue to weigh on the U.S. economic outlook.”

While in the context of the current backdrop of weak global trade and the downturn in the global technology cycle does matter to the emerging economies like Philippine, Turkey, etc. We estimate trade elasticities for the Philippines and conclude that the external and domestic demand are the dominant respective drivers of exports and imports. In contrast, the exchange rate has a relatively minor bearing. Most EM currencies continue to appreciate vs the Euro and US Dollar.

In emphasizing downside risks to the outlook, Powell has defused the immediate risks of a disruptive back-up in bond yields. This has put a cap on the broad dollar. Bond proxies in FX such as CHF and JPY have been spared a potential fixed income VAR shock.

That being said, we do not believe that Powell has given a green light to sell USD indiscriminately. Nor do we see it as a reason to embrace pro-cyclical FX as the global economy continues to come up short. This macro backdrop still warrants strategically overweighting defensive FX in G10 irrespective of Fed easing.

EUR has been resilient to the latest under-delivery from the region’s economy. But with the ECB no longer content to sit this out, the downside threat to EUR is becoming more tangible. QE1 depressed EURUSD by 12% on the ECB’s own estimates.

Powell makes room for options carry but with FX vols back to the YTD low an uneasy feeling returns.

Collect BRL vol carry via delta-hedged -3m/+12m calendar spread, via delta-hedged ratio put spread or sell a capped downside digital strangle.

Sell GBP - commodity FX correlation as GBP’s idiosyncratic dynamics should lead to low correlation with other cyclical FX. 

EURTRY continues to be side-lined above the 200-day moving average at 6.3115. The pair bounce off the 200-DMAs at 6.3115 has so far taken it to last week’s high at 6.5015. 

If bettered, the March high and the 55-day moving average at 6.6077/6.6250 as well as at the 6.6952 mid-May low would be in focus. 

Simple vanilla carry structures in 3M EURINR and EURTRY put spreads deliver above-average >4x gearing. 3M EURINR at-expiry-digital is a standout downside structure that offers an attractively priced hedge for ECB QE. Courtesy: JPM & BNP Paribas