FxWirePro: Is Euro Vulnerable Amid Fragile Transitional And Pandemic Phase? EUR/JPY OTC Outlook And Hedging Strategies

The Eurogroup meeting has been adjourned. The eurozone finance ministers could not agree on any plan to manage the financial burdens of the corona crisis.

Well, everyone (including myself) had imagined this to be so easy: many euro zone countries would want corona bonds, but Germany, Austria and the Netherlands would object to that and that as a result they would make do with an ESM package. Whether they wanted to or not and in the small hours. But that that was what would happen in the end. But clearly things are not that simple. Why is it so difficult? Europe is trapped in a fragile transitional state: "No bailout" was abandoned in 2010 when it first became relevant. There is no going back. But nobody is prepared to take the step towards a deeper union and to create the institutional framework for it, e.g. a proper EU parliament with general and equal elections, with complete rights to initiate legislation and budgeting rights and the right to select a government. As a result we are left with the current piecemeal situation in which every debt naturalization would create a ton of new issues and would therefore not get broad support even in the most dire emergency when lives are literally at risk.

Analyzing to what extent the damage this does to the idea of a single Europe is difficult. That would be so depressing. So, we emphasize the effect on the EUR exchange rates. That is reasonably simple. For the euro a failure of the Eurogroup meeting is the worst possible scenario. EURJPY tops the list of the liquid pairs that offer ex-ante risk/reward metrics in particular. The major trend of this pair has been bearish that remains intact.

Sure, the finance ministers will continue with a next round tomorrow. And in the end the heads of state and governments could solve this issue at a special summit, if their ministers will fail again. Nevertheless, the chance that no dal can be reached at all is no longer insignificant. That could imply that bond markets go ballistic and/or that the ECB will have to fire new bazooka rounds.

OTC Outlook: Most importantly, (at spot reference: 118.24 levels) 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 114 levels). 

To substantiate the above indications, we could see fresh positive bids amid the EURJPY's 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, 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