FxWirePro: Euro seems resilient ahead of ECB – Hedge EUR/JPY skews and risk reversals

In emphasizing downside risks to the outlook, Powell has defused the immediate risks of a disruptive back-up in bond yields. This has put a cap on the broad dollar. Bond proxies in FX such as CHF and JPY have been spared a potential fixed income VAR shock. 

That being said, we do not believe that Powell has given a green light to sell USD indiscriminately. Nor do we see it as a reason to embrace pro-cyclical FX as the global economy continues to come up short. This macro backdrop still warrants strategically overweighting defensive FX in G10 irrespective of Fed easing. 

ECB has been scheduled for its monetary policy on July 25th, and EUR has been resilient to the latest under-delivery from the region’s economy. But with the ECB no longer content to sit this out, the downside threat to EUR is becoming more tangible. QE1 depressed euro by 12% on the ECB’s own estimates.

ECB minutes were dovish but not as dovish as Draghi’s speech in Sintra. The minutes of the ECB’s June meeting were dovish, as was our reading of the meeting at the time, but not necessarily as dovish as Draghi’s speech in Sintra (with the caveat that Draghi’s speech was clearer about the need to act again than about the required magnitude of the policy move).

OTC Outlook:

Hedging skewness (EURJPY): Please be noted that the positively skewed IVs of 3m tenors that are also signifying the hedging interests for the bearish risks. The bids for OTM puts of these tenors expect that the underlying spot FX likely to break below 119.50 levels so that OTM instruments would expire in-the-money. 

Risk reversals Substantiate Skews (EURJPY): Most importantly, to substantiate the above indications, we could see some minor positive shifts in existing bearish risk reversal set-up of EURJPY that indicates the long-term hedging sentiments across all tenors are still substantiating bearish risks amid minor abrupt upswings in the short-term. Please be noted that 3m IVs are overall OTC barometer is a noteworthy size in the forex options market that can stimulate the underlying forex spot rate.

Options Trade Recommendation (EURJPY): We’ve advocated buying 3m EURJPY (1%) ITM -0.79 delta puts for aggressive bears on hedging grounds as the mild abrupt upswings were contemplated earlier. 

Alternatively, we advocate shorts in futures contracts of mid-month tenors with a view to arresting potential dips. Source: Sentrix and Saxobank