FxWirePro: Driving Forces, OTC Outlook And Hedging Strategies Of EUR/JPY

Universal fact is that the strength of a relationship would be severely tested during times of crisis. This is currently very obvious in the EU, and the euro is not taking it well. There is no agreement about how to support the member countries most badly affected by the virus. Suggestions have been made to use funds from the ESM (European Stability Mechanism) on a euro level. France wants to see the introduction of a EU fund to finance economic recovery programs. The Netherlands favour a fund aimed exclusively at dampening the economic effects of the corona virus but do not support any widespread measures. The European Commission on the other hand is suggesting a European plan for reduced working hours (Initiative "Sure"). In view of the number of proposals there is a risk that a rapid agreement will not be reached. That does not set a positive sign that the EU is unable to work together during such a difficult crisis which cannot even be blamed on an individual country. However, Europe is not an isolated phenomenon in this respect. Only a short while ago the US Congress was locked in a debate about an aid programme over several days. But admittedly that is of little consolation.

Already released industrial production data for the four largest Eurozone economies showed that output in the factory sector fell sharply in December. That points to a big slide in production for the region as a whole and we look for a monthly decline of 2.1%. Euro looks to be vulnerable again as the larger-than-previously-expected fall points to downside risks for Q4 GDP growth and we think that Friday’s update will see a downside revision to no change from the initial estimate of 0.1% GDP growth. 

On the flip side, one reason for the Yen’s appreciation when entering a global recession is that investors with speculative JPY short positions face increased volatility and buy back JPY to close their short positions; we note that there was a rapid reduction in speculative Yen shorts leading into the start of the 2008-09 recession in particular, as market recession expectations were re-aligned. From a fundamental point of view the market reaction is understandable.

OTC Outlook: Most importantly, the positively skewed EURJPY IVs of 3m tenors are also signifying the bearish risks in the underlying spot (refer 1st exhibit). The bids for OTM puts indicates that the hedgers expect the underlying spot FX to show further dips so that OTM instruments would expire in-the-money (bids up to 111 levels). 

To substantiate the above indications, we could see fresh negative bids in the EURJPY bearish risk reversal (RR) set-up that indicates the long-term hedging sentiments across all tenors are still substantiating bearish risks (refer 2nd exhibit). Hence, we advocate below hedging strategy contemplating the above drivers and OTC indications.

Options Strategy: Contemplating above factors and the prevailing underlying sentiments, we’ve advocated buying 3m EURJPY (1%) ITM -0.79 delta puts for aggressive bears on hedging as well as trading grounds as the mild abrupt upswings were contemplated earlier. 

Short Hedge: Alternatively, ahead of above-stated data announcements that are scheduled for the next week, we advocated shorts in futures contracts of mid-month tenors with a view to arresting potential dips, since further price dips are foreseen we would like to uphold the same strategy by rolling over these contracts for March month deliveries. Source: Sentry, Saxo & Commerzbank