FxWirePro: Tailwinds On Cards For Euro But Prudent To Hedge Cyclical Headwinds And Breath With Digital Call Options

The Euro area economy disappointed again in 2019, so too EUR. We had expected a four cent rally on European reflation, instead we got a three cent decline in EUR/USD on an extended European downturn.

The 2020 forecast envisages a belated lessening in cyclical headwinds that should enable a modest EUR recovery in line with the pull from cheap valuation and its record balance of payments support.

EUR’s basic balance surplus is 5.7% of GDP versus modest deficits in the US and Japan. This surplus should cushion the EUR against further cyclical disappointment and leverage it to genuine reflation. The option market concurs with this asymmetry to judge from the positive EURUSD skew.

The EURUSD forecast is rolled to 1.14 for end 2020, a one cent upgrade to account for the lessening in cyclical tail risks and to reflect some hint of a US political risk premium in election year.

Fiscal policy should turn supportive for EURUSD in 2020, not so much from a loosening in Euro area policy (this will add maybe 0.2- ppt to growth), but instead the end of Trump's Keynesian boom. While Monetary policy by contrast offers little respite from record-low vol in EURUSD but on balance should be supportive for spot. The Fed is tentatively on hold but biased to ease again whereas Lagarde’s ECB may be more cautious in expanding QE and exploring the ELB. 

The overall risk bias is positive reflecting EUR’s strong structural fundamentals and US political risk 

Hedging Strategies: Contemplating above factors, initiated long in 2 lots of EURUSD at the money -0.49 delta put options of 3M tenors, write an (1%) out of the money put option of 2w tenors, (spot reference: 1.1063 level). Short-legs go worthless as the underlying spot price hasn’t gone anywhere. Any slumps from here onwards are to be arrested by the 2 lots of ATM long-legs.

Those who are sceptic about mild rallies, 3m 1% in the money puts with attractive delta are advised on a hedging ground. Thereby, in the money put option with a very strong delta will move in tandem with the underlying.

Those who want to participate in the prevailing rallies in the short run, one can freshly initiate the strategy. The directional implementation of the same trading theme by further allow for a correlation-induced discount in the options trading also if you choose strikes appropriately.

Stay long trade in EURUSD digital call:
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.

Add longs in a 3M 1.15 digital EUR call/USD put for 11.5% (spot ref 1.1012). Marked at 16.7%. Courtesy: JPM