FxWirePro: Smart hedging for softer dollar shorts post Fed speeches

After being gripped slightly by geopolitically-driven risk aversion last Friday, expect markets to be guided by central bank rhetoric this week despite the plethora of geopolitical/political headlines over the weekend. At the onset of the week, apparent USD resilience we think would be more a function of the implicit uncertainty surrounding several of the other major G10 currencies.

September FOMC: Downplays softness in inflation and maintains its hiking signals. In the FOMC post-meeting statement, the updated economic projections did not include any major changes compared to June, highlighting that the potential disruptions from various hurricanes are expected to prove short-lived and not to alter the US economic outlook over the medium term.

In the press conference that followed the conclusion of the meeting, Fed Chair Janet Yellen explained the Committee’s view that core inflation weakness in 2017 is “largely unrelated to broader economic conditions”, expressing their expectation that, when the various temporary factors fade, inflation will return to the Fed’s medium-term target of 2.0%.

Little appears to have changed on the surface for the dollar bear trend so far judging from the placid price action in the aftermath of the first upside US CPI surprise in six months –perhaps in part because it was pre-empted by last week's dollar bounce –but profit taking on dollar shorts in coming weeks is a decent possibility in our view. As the Outlook section of this publication details, US politics has temporarily receded as a dollar drag, fresh impetus for Euro strength does not appear imminent, Chinese growth momentum is ebbing and PBoC bias has shifted against additional CNY strength –all of which point towards a period of risk reduction of extended dollar shorts even if full-throated embrace of dollar bullishness is some way off.

Taking some chips off the table when existing (and profitable) market themes appear to be losing steam strikes us as the path of least resistance for an alpha-starved macro investor community, absent  of course a dovish revision of the long-term Fed dots in the September.

The vol implications of such a position adjustment are murky. Demand for optionality to participate in the dollar decline of the past few months was ostensibly one of the key drivers for the upturn in implied vols since late June, so unwinds of bearish dollar structures should be symmetrically vol dampening at the margin.

On the other hand, realized vols are liable to stay firm since even a small shakeout in what is a substantial short dollar overhang can lead to good-sized spot gyrations. The net result is that the belly of vol curves (3M-6M) may experience greater pressure over the next few weeks than gamma-sensitive tenors, and short-dated implieds will probably find a base once next week's (admittedly heavy)  FOMC event risk rolls off the expiry calendar. Long gamma, flat/selectively short vega is the appropriate ex-ante vol portfolio orientation if we are correct on flow dynamics. Courtesy: JPM