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With COVID-19 uncertainty running rampant across the Eurozone, and the US and the UK only a few weeks behind, we look for defensive expressions that commit limited premium this late in the cycle and utilize a combination of generic risk-off and EUR and/or GBP lower to achieve premium savings. Our macro team highlights the vulnerability of GBP to repatriation flows amid COVID- related lockdown with no buffer from existing short positions, making GBP an attractive candidate for defensive leveraged structures of the form (GBPUSD lower, USD/X lower) that achieve premium savings by selling USD correlation.
In addition, the recent decline in EURUSD, and the attendant re-pricing of riskies into negative territory (for EUR puts) biases risks in the direction of further EUR weakness in a rising vol environment. For the risk-off currency paired against the USD, we consider JPY, CHF, and XAU as traditional safe haven currencies and also add SGD to the list.
The 2nd chart ranks EUR and GBP lower vs USD/X lower dual digitals based on their discount to individual at-expiry digitals, a common measure of assessing correlation savings. The short USD correlation structures show quite substantial savings across CHF, JPY, and XAU. At 65% discount, and cheapest in % price terms, the GBP-JPY combination is possibly the most eye catching. At odds with the ongoing COVID-19 developments, GBP-JPY via USD implied correlations are near the multi-year high. Even absent the virus scare, the simmering idiosyncratic Brexit issues should be adding downside pressure to the GBP-JPY correlations, a long-term issue that is supportive of the structure tenor extension.
A back-test (refer 3rd chart) shows historical returns from 3M (GBPUSD dn, USDJPY dn) dual digital to have been strong overall and particularly during vol episodes. Encouragingly the cumulative P/L held even as the GFC period vols started to come off the peak at the end of 2008. Term structure of implied correlations for the EUR downside case (refer 1st chart) indicates 1M-2M tenor to have better value, a pattern also at play for the GBP case. This can be explained to some extent by the 1m realized correlation holding up well.
However, in light of the recent drop of EURUSD riskies into negative territory, and considering the -9 vols USDJPY downside riskies are pricing, it would not be unreasonable to consider a scenario where both USDJPY and EURUSD drop if extreme risk- aversion continues.
On JPY, we stress that the central house view is that USDJPY would remain supported in case of further financial deleveraging. For this reason, we prefer looking for USDJPY near the money. Also, downside digital structures on USDJPY are supported by the near GFC, extreme pricing of riskies. Courtesy: JPM
