FxWirePro: What’s Driving Euro? EUR/USD OTC Updates And FX Derivatives Trading & Hedging Setup

Risk markets have had a solid start to 2H with equities, industrial commodities and high beta currencies all performing well in the aftermath of solid June PMIs which showed a record increase in the manufacturing component. While the dollar strengthening amid the risk-off trade at the end of the last quarter has thus been completely reversed and the broad dollar is once again bumping against the lows of its post-COVID range.

However, the fallout on currency markets is quite evident — EURUSD (the euro bloc) has steadily headed higher as activity data has normalized quicker in the US (refer 1st chart). Meanwhile, the broad dollar has weakened driven by the double whammy of a broad-based recovery taking hold globally and the US lagging this move.

Looking ahead, there are several factors that are likely to contribute to the euro bloc outperformance intact at least in the near term, even if longer-term prospects are more tenuous.

Even though the economic costs of the outbreak are likely to be less dire than that in March given lower mortality rates and a better understanding of the virus spread, it is reasonable to assume that the outbreak will inhibit normalization in the US relative to Europe. The flash PMIs next week will shed more light on this dynamic and we view risks to EUR skewed to the upside going into that release.

Second, the EU council meeting and the scope of the recovery fund will be in focus over the weekend. A deal is certainly possible this week but our economists’ expectation is that another round of discussions will likely be needed in late July.

For FX, our view is that the recovery fund itself is not likely to be transformative for the currency over the longer run but certainly in the near-term, an agreement is bound to heighten investor focus on the European valuation trade in the near-term.

OTC Updates:

EURUSD risk reversals are trading positively again for tenors below 3-months, and at almost zero for 3-months (refer 2nd chart). Why’s that so, is this because the dollar is less suited as a safe haven? Perhaps marginally. Above all because the market is considering the risk of a second wave of the pandemic to be low and considers a major, risk-driven slide in EURUSD to be less likely. Otherwise butterflies would not be virtually back at pre-corona levels. That might be sensible pricing levels for all those market participants who can spread their risks. Anyone not able to enjoy that luxury might be pleased about this good opportunity to hedge non-diversified risks against a renewed wave of risk aversion.

EUR risk reversals have still been indicating the hedging sentiments for the bearish risks in the long run, as the fresh negative bids are added to the positive RRs for 1-3m tenors (2nd chart).

Most importantly, the positively skewed EURUSD IVs of 3m tenors are stretched on either sides but with slight biasness towards downside hedging risks (refer 3rd chart), while IVs are shrunk below 6.75% across major tenors.

Hence, considering all these factors, the below options strategies are advocated.

Options Strategy: Contemplating above factors, we advocated 1m butterfly spread on trading grounds. Initiated longs in 1m OTM -0.49 delta put while simultaneously shorting ATM put with similar expiries and buy 1m OTM 0.5 delta call while simultaneously shorting an ATM call with similar expiries. This strategy is structured for a larger probability of earning a smaller but certain profit as EURUSD is perceived to have a low volatility.

Alternatively, with an objective of arresting upside risks, we recommend long hedges of August tenors as we could foresee further upside risks in the days to come while the pandemic and macroeconomic turmoil remain intact. Courtesy: Sentry, Saxo & JPM

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