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Following some rather dull trading days, USD traders had actually hoped for today’s semi-annual hearing of Fed Chair Janet Yellen in front of Congress to bring some life into the exchange rates. But then things happened in rapid succession yesterday - to the dollar’s disadvantage.
The focus of USD investors rests mainly on monetary policy again. Following yesterday’s comments of FOMC board member Lael Brainard a Fed timetable seems to be increasingly emerging that corresponds to the one long since favored by us: the Fed is likely to announce the imminent end of the reinvestments from the QE programme in September.
No clashes with low-intensity jitters continuing through this month as the position shakeout in duration-heavy bond markets play itself out; indeed, the recent FX price action is very much in line with our baseline 2H’17 view of a moderate turn higher in vol. At the same time, however, we are skeptical that the ongoing bond sell-off will morph into a more sinister trigger for risk markets.
That said, these are not placid markets and there are a couple of lessons to be gleaned from the pattern of recent vol returns that can prove useful for defensive option plays:
Gamma is performing solidly, and comfortably outpacing vega (refer above chart), which is to be expected when markets go into a pothole with ultra-low levels of frontend vol and steeply upward sloping vol curves. Vol curve flattening was indeed one of our core views for H2, and the upbeat performance of vega-neutral, long gamma calendars supports our conviction in employing them as defensive vehicles.
The currency bloc breakdown of gamma returns in the above chart is divulging. EURUSD and EUR/EM are the best-performing currency pairs, while USD/EM, GBP, and AUD-crosses have been disappointing. In general, owning gamma in USD - pairs and EUR - crosses - the two currencies at the heart of the rate normalization dynamic - appears to be a decent rule of thumb. The underperformance of USD/EM as a bloc is surprising and illustrates the wide dispersion in EM FX behavior.
