FxWirePro: What’s driving dovish tone in momentary policy season and tepid VXY?

Even with two major central bank meetings in the coming two weeks, broad FX markets look likely to continue the drift into early summer markets.  The weak payrolls report will reinforce expectations that June’s Fed hike will be a “dovish” one, while EUR indicators suggest already high expectations for ECB policy normalization signaling. 

And so fresh impetus to either EUR or USD into the start of summer appears elusive. The lack of fresh directionality in markets is also due to the fact that despite various significant headlines in the past several weeks (e.g. China overtightening and US presidential scandal risks), none has followed through and endured as multi-week driving narratives of global markets. 

We review two fresh global market developments that we, as a baseline, expect to also remain largely local idiosyncratic developments: the renewed RMB FX regime shift in China, and the upcoming UK election.

FX Derivatives: VXY has retraced nearly 100% of its Brazilian and US political stress led spike, once again leaving it looking meaningfully cheap vs. cyclical drivers.

FX vols have drifted lower over the past two weeks with political eruptions in Brazil and the US fading into a dull background monotone. VIX, as well as BRL vols, have retraced 100% of their spike, as has the collateral damage in yen-crosses and other EMs.

The OPEC meeting in late May could have proven to be a banana skin for risk markets, but that too was safely negotiated by avoiding the unpleasant ‘no-deal’ tail, leaving the VXY once again looking meaningfully cheap to cyclical variables but starved of catalysts to trigger mean-reversion. June brings a nearly 100% discounted Fed hike, an important ECB meeting and surprisingly tight UK elections as key events, none of which look likely to upend the low quality carry environment that has prevailed since the French elections.

Of the three, the ECB strikes us as the most meaningful and tradeable from a gamma standpoint given the substantial weight of existing EUR positions and the potential for any disappointment on tapering expectations to move markets; jockeying around of Italian election day-weights in coming weeks adds a layer of excitement for Euro-bloc option markets.

The spike in front-end ATM vol and nosedive in risk-reversals after this week’s USD/CNH plunge is over-done, fade the move via -6w/+3M calendar spreads and AUD vs. CNH 2M gamma spreads. Italian election risk premium is priced to the tune of ~60% of peak French election risk and far from fade territory. EURCHF, EURJPY, and EURUSD are the biggest laggards by the French yardstick; stay long EURUSD 1M1M FVAs into next week's ECB.