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What are the lessons of 2019, what does that mean for 2020, what are the implications of the UK election result, where are the risks in emerging markets, how could the trade war develop, is a currency war already in full swing, and what are the long-term issues for the foreign exchange markets, all of which are to be meticulously contemplated before we position our FX exposures into 2020.
Well, for the financial markets, the key takeaway from 2019 is that "normalisation" seems most unlikely to happen in the foreseeable future. We will have to set ourselves up in a world of low interest rates, low inflation and permanently expansionary monetary policy. Central banks will be less active, so FX volatilities will remain low, even if the EURUSD sideways movement is unlikely to last. The best news from the ECB is that it will do nothing while the Fed will have to confront for its status in 2020.
After low FX vols throughout this year, the year-2020 is one year where we know that the probability of the baseline forecast being realized is unusually narrow, given its dependence on a number of uncertain binary outcomes, starting with:
1) US-China truce vs re-escalation and
2) An orderly vs still messy Brexit, but which also include
3) A progressive vs moderate Democrat alternative to Trump in 2020 and, to a lesser extent 4) Whether President Trump survives the impeachment hearings.
We run you through some major FX markets themes for the upcoming new-year 2020:
With the above-stated baseline, predominantly, six themes are emphasized which we reckon are relevant for navigating the FX markets in 2020:
1. How vigorous will global lift be, given that a more comprehensive US-China deal is unlikely and the global economy is inescapably late-cycle?
2. Is this year’s round of Fed easing a mid-cycle pause that refreshes the US expansion, or a down-payment on a full-blown easing cycle?
3. How and when should markets price in US2020 election risks?
4. Is NIRP outliving its welcome? Enthusiasm for negative rates appears to be waning, what does this mean for the cheap, surplus currencies with negative rates, especially if global growth continues to disappoint and the Fed continues to ease?
5. Global monetary easing calls into question the sustainability of large current account imbalances as the capital account recycling of these imbalances will become progressively harder under conditions of ever tighter interest rate spreads. European currencies are well placed to benefit from this.
6. Low vol for now, for longer, or forever? FX vol is undershooting its cyclical drivers by a record 3 % pts. Hopes for mean reversion rest with politics, not economics.
Factoring-in all these underlying drivers, we are tactically inclined to stay long EURUSD digital call and buy 3Mx3M USDCHF FVA @5.55/5.85 indicative. Spot ref 0.9966. Marked at 5.63 vol pts.
Prices for levered versions of call spreads have recently been the lowest in five years due to record low base vols and positive risk reversals. So while the timing for European reflation trades is not ideal absent better data, this is partly offset by attractive cost considerations. The strong Conservative majority provides some support to EUR as well, and we keep an eye on momentum above 1.12. Broad-dollar selling into 1Q should further support the trade.
Long a 4M 1.15 digital EUR call/USD put for 11.5% (spot ref 1.1012). Marked at 16.7%. Courtesy: JPM