FxWirePro: Spotlight on FX Derivatives Themes For H2’2020

As the markets are entering 2H’20 with the unprecedented levels of Covid-19-induced economic uncertainty that is likely to be compounded by the political volatility through the US election season, neither of which is reflected in the price of FX volatility.

With that said, relatively tame levels of VXY are consistent with the concerted decline in G7 policy rates towards zero. These offsets leave us with a net mildly bullish bias on VXY/ cautious view on risk for H2.

As the dollar buying was observed, due to risk-off moves from Covid-19 cases re-accelerating in the US, USDJPY surged back up to the 107.00 level. However, there weren’t enough catalysts to drive USDJPY in either direction and the pair remained range-bound. Domestic investor flows still appear limited, but the price action when USDJPY falls would seem to imply that dip-buying appetite is quite strong.

In Eurozone, FX markets diverged from their usual relationship with other risk assets from the recent past. This was most prominently seen in NOK being the worst performer among G10 space, weakening about 0.5% against the USD despite a 1% rally in oil prices and slightly stronger equity markets. While EURUSD was also weak throughout the day, breaking below 1.12 at one point, even though Eurozone equity markets outperformed. The sustained move lower during the London morning session coincided with the move lower in the German-US 10y yield differential. The EUR weakness comes despite more signs of a reduction in the risk of the German constitutional court ruling limiting the ECB’s ability to buy government bonds in the future. After Wednesday’s reports suggesting the ECB will release documents to the Bundesbank that can be used to prove the PSPP’s proportionality, the ECB minutes set out in detail the reasoning behind why the PSPP was proportional and effective, and the German constitutional court rejected a separate court case challenging the ECB’s 2015 expanded asset purchase programme.

GBP weakened relatively less, by 0.3% against the USD, with EURGBP down 0.2% on the day but staying above the 0.90 level amidst mixed news on the Brexit front. On the positive side, EU’s chief Brexit negotiator Barnier signalled on Wednesday willingness to find a compromise on the level playing field and fishing issues. On the other hand, the UK’s chief Brexit negotiator Frost rejected the possible compromise floated in the media, that the UK would have the right to deviate from the EU’s level playing field if it chooses to but the EU could impose tariffs if this happens.

Risk-off sentiment drove the price action in EGBs, with Bunds opening stronger and core duration outperformance continuing throughout the European session. The reaction to the ECB minutes, where the central bank set out a view that PSPP purchases were proportional to policy objectives (in an apparent response to the GCC ruling), was muted. 10y German yields slid to this month’s low of -0.47%, with decent bull flattening pressure on the curve.

Contemplating above factors, FX option themes can be structured for H2 in four buckets:

i) constructive USD-based correlations, more so within the alternative reserve currency bloc (long CHF vs. JPY corr via USD);

ii) Brexit-induced GBP de-coupling from cyclical FX (short GBP vs. CHF, JPY corr);

iii) The equity vs. FX re-correlation on non-US reflation (EUR vs. SX5E, JPY vs. NKY dual digitals); and (iv) US election risk premia (generally cheap outside of USDJPY). We would run you through with those strategies well in detail in our upcoming posts. Courtesy: JPM