FxWirePro: Fair interpretations of USD correlations and running GBPJPY vs USDJPY and BRLJPY vs USDBRL Vega spreads

The USD has continued to make fresh highs as the combination of ongoing global cyclical disappointment, and relative US cyclical outperformance adds fuel to the unwind of USD shorts. 63% of the extreme short dollar base seen earlier this year has unwound, similar to the proportion of the extreme dollar discount unwind, which now shows the USD only 4.7% cheap versus 5y rate spreads, from near 13% in mid-February.

Watching for cracks in the USD correlation wall: The re-syncing of US rates and the dollar has spurred across- the board USD strength over the past month, and there are few signs yet that indiscriminate dollar buying is giving way to greater differentiation (80% -100% of G10 and EM currencies have weakened vs the greenback over 1-wk, 2wk and 1-mo trailing windows).

The natural corollary of a universal dollar rally is that USD-based implied correlations have climbed to near range highs (refer 1st chart), and are worth watching for cracks as a gauge of whether risk sentiment is worsening.

One oft-repeated FX pattern during risk-off episodes is an initially broad USD surge, followed by an even more intense bout of deleveraging characterized by a cratering of yen-crosses and breakdown in JPY/high-beta correlations that mean-reverts a USD-correlation index to its local lows –see shaded bars in (refer 1st chart) for examples; notably, this was also the experience of the taper tantrum episode that the current bout of Treasury weakness is being increasingly likened to, when the Abenomics/QQE-I fueled uptrend in USDJPY was rudely interrupted by a serious bout of cross-yen selling.

We have been running GBPJPY vs USDJPY and BRLJPY vs USDBRL vega spreads in our model portfolio for a while now as protection against such disorderly price action. At current levels, directional investors could consider JPY put/KRW call spreads or digitals that are well-priced within the subset of defensive cross-yen plays (refer 2nd chart) e.g. 3M 10.20 strike digital JPY calls offer 5.5 times gearing (spot ref. 9.72). Courtesy: JPM

Currency Strength Index: FxWirePro's hourly JPY spot index has shown 158 (which is highly bullish), while hourly USD spot index was at 2 (absolutely neutral) while articulating at 09:17 GMT. For more details on the index, please refer below weblink:

http://www.fxwirepro.com/currencyindex.

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