FxWirePro: A Glimpse At Option Themes As FX Markets Enter H2’2020 Along With Pandemic Covid-19

We can only repeat it like a broken record: the fact that sentiment indicators in the eurozone have been rising heavily for the past two months and have even come in above expectations does not mean that everything is fine, that we will see a V-shaped economic recovery and that soon we can go back to normal. Quite apart from the fact that the indicators remain below the 50 mark, and are therefore contracting, the effects of the massive economic collapse in the spring will still be felt for some time and the recovery will be slow as a result. Some economic sectors, companies or consumer behavior might even have been affected permanently. It seems imprudent to me to be strongly buying euro - like yesterday -, based on the indicators and to put all worries aside.

However, the risk of a second wave worldwide has not been banished yet and can quickly push the FX market back into the old pattern of risk aversion is on the up, let’s buy safe havens, i.e. the dollar, even under the assumption that the lockdowns imposed in that case would probably be much less severe than the first time around. However, not only the second wave of infections can be used as an argument for optimism fading again. The confusion about the alleged end of the phase 1 agreement between China and the US at the start of the week illustrated how quickly sentiment can turn, causing a reversal in EUR-USD due to a short spike in risk aversion. I expect the euro to hit some decent resistance in the area of 1.1400-1.1420 – if not before.

Apprehensions over mounting coronavirus cases in southern and southwestern regions of the US resulted in equities paring gains towards the close on Wall Street (although the Nasdaq reached new highs) and weighed on stocks in Asia.

It was clear from market volatility on Tuesday morning that US-China trade tensions have not been brushed aside as initially thought. White House adviser Peter Navarro spooked markets with his comment that the US-China trade deal was over; US stock market futures fell and the USD rose. Markets reversed course after US President Donald Trump said that the deal was “fully intact”. US Treasury Secretary Steve Mnuchin expects China will live up to its trade deal with the US. Amidst the worst US recession and jobs market since the Great Depression, President Trump would not want US equities to weaken ahead of the November elections.

As end-quarter looms and fresh weekly auctions for 3Q’20 kick in, investors will seek reassurance from domestic agents (RBI, banks, insurance firms, etc.) of their ability to absorb the incremental increase in supply. We continue to look for 10Y yields to ease towards 5.5% next quarter, counting on further easing and central bank’s support. Debt FPIs stayed away for a fourth month into June, not helped by sticky FX hedging costs and flat currency, besides trepidation over the macro outlook.

Markets are entering 2H’20 with unprecedented levels of COVID-19-induced economic uncertainty that is likely to be compounded by US election volatility. Neither is reflected in the price of FX volatility; however 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 for H2.

Overall, commodity currencies and, to a lesser extent, European currencies will continue to be correlated with US stock market futures. AUD remains the most responsive, followed by NZD, CAD, GBP, and EUR. This was evident in the manner AUDEUR fluctuated with US stock futures yesterday. The NZD will probably be vulnerable to any downward correction today. The Reserve Bank of New Zealand meets today and has a negative rate bias later this year or early next year; the last monetary policy statement has projected a trade-weighted depreciation for the NZD. 

FX option themes:

i) Constructive USD-based correlations within the alternative reserve currency bloc;

ii) Brexit-induced GBP de-coupling from cyclical FX;

iii) Equity vs. FX re-correlation on non-US reflation; and

iv) Playing US election risk premia (generally cheap outside of USDJPY). Courtesy: JPM, DBS & Commerzbank

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