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In all possibilities, the expectations are rising that the Fed would cut its key rate by the end of this month. The size of the rate step, however, is still uncertain. Two scenarios are being discussed right now. The first assumes a one-off rate cut of 50 bp or less in July, the second a series of cuts. The latter would clearly be more of a burden for the USD. Which scenario materializes will depend on the future development of the US economy and inflation figures. That is why one would expect the market to be largely data-driven in the coming weeks.
Unfortunately, however, the market does not seem to have understood the Fed’s reaction function in full. In any case, it had been too optimistic about the good labor market report and had to adapt its stance after Fed Chair Jay Powell’s statements last week. All depends on finding the right mix. We, therefore, expect the USD exchange-rate reaction to the US data to be modest for now and only to strengthen once its direction is confirmed by statements by Fed officials.
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, potentially until the FOMC at month-end. Bond proxies in FX such as CHF and JPY have been spared a potential fixed income VAR shock, for now.
That being said, we do not believe that Powell has given a green light to sell USD indiscriminately, certainly not within G10 even if selective EM carry can continue to perform. Nor do we see it as a reason to embrace pro-cyclical FX as the global economy continues to come up short relative to expectations.
As the bearish trend in FX volatilities continues, the appeal of buying optionality at low entry levels clashes with the negative time decay options suffer when catalysts for higher realized vols are missing.
FX vols got dragged down to the YTD low over the past few weeks amid synchronous dovish shift among the major Central Banks.
Collect BRL vol carry via delta-hedged -3M/+12M calendar spread, via delta-hedged ratio put spread and/or sell 2M range as a capped downside short digital strangle. Positive carry from selling 3M delta- hedged skews is attractive in USDHUF and USDPLN.
Sell GBP - commodity FX correlation as GBP’s idiosyncratic political dynamics should lead to low / no correlation with other cyclically sensitive FX.
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 risk from ECB's QE.