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FxWirePro: FX/rates trades revisit and reassessment as Trump clatters geopolitics again

President Trump has rattled FX and rates markets by surprisingly turning his attention back onto Mexico, placing 5% tariffs on imports, which will rise to 25% in October unless illegal immigration stops. The US President announced that as of 10th June tariffs of 5% are going to be imposed on all imports from Mexico.

This obviously puts last year’s North American trade agreement in jeopardy. The renegotiated NAFTA agreement (“USMCA“) isn’t worth the paper it is printed on. Any assertions to the contrary on the part of the White House Chief of Staff stating “that is separate and apart from the USMCA” would seem funny if these developments weren’t so sad.

Anyone who is currently negotiating a trade agreement with the US or is going to do so in future will remember this episode.

As a result, the Mexican Peso dropped by around 2.5%, while the US yields and crude oil prices were also fallen considerably. The latter has not been helped by Chinese manufacturing PMIs slipping back below 50 into contraction territory. Near term, the broad USD is underpinned perhaps by month-end rebalancing.

For the US administration, trade war appears to be a tool for enforcing its will on other nations as part of the geopolitical option. 

But for the FX market, it implies that: The time for the reassessment of the recovery of the Mexican peso that we saw in early 2017 when hopes first arose that NAFTA might be saved.

The initial USDMXN reaction (from 19.10 to 19.60) is small in comparison to USDMXN temporarily trading at a level around 22.00 back then.

While there has to be something good about the greenback, otherwise rising speculation about Fed rate hikes would not leave it so totally unaffected.

Trade reassessment: 

Vols spiked across asset classes on rising risks of a breakdown in trade talks, led by U.S. credit and short-term rates. At current levels vols look modestly rich across the surface, but could be pricing in event risk premium not captured by the usual drivers; we focus this week on the skew.

By comparison to historical vol-rate delivery, as well considering dealer gamma hedging and asymmetric liquidity dynamics, out-strike receivers on 10-year tails look cheap; buy the OTM strike of 1x2 receiver spreads in 3Mx30Y swaptions.

Elsewhere, Delta hedged 1*1.5 ratio call spreads have been advocated that exploit the dislocation while also having historically offered a superb performance. +1Y/-3M calendars of risk reversals take advantage of the lagging back-end vs front-end implied skews. We wish to uphold the same strategy for now.

The previous massive sell-off of Mexican peso caused a vol surface dislocation, nudging skews to the highest since the 2016 US Presidential elections. Delta hedged 1*1.5 ratio call spreads exploited the dislocation while also having historically offered a superb performance. +1Y/-3M calendars of risk reversals take advantage of the lagging back-end vs front-end implied skews. Courtesy: JPM & Commerzbank 

Currency Strength Index: FxWirePro's hourly USD spot index was at 81 (bullish) while articulating (at 12:09 GMT). 

For more details on the index, please refer below weblink: http://www.fxwirepro.com/currencyindex

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