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Markets would be observing the effectiveness of the RBA’s QE program and yield target. A fair level for 3yr swap rates would be around 0.40%, but pandemic-related volatility will result in a wide range, say 0.25%-0.50%. The curve should flatten given RBA ACGB purchases.
While constant edginess around the global risk backdrop so distinctly visible in AUD risk-reversals is nowhere to be seen at the long-end of the vol curve in AUDJPY, the bellwether risk-sensitive cross in G10 FX. A surprising – and rare – RV set-up in option markets today is that 1Y1Y forward volatility in AUDJPY is marked marginally under 1Y1Y AUDUSD forward vol on mids. Because AUDJPY spot on average moves almost at par with AUDUSD on normal days but by as much 1.3x – 1.4x in high vol periods, no AUDJPY vol variable ought to be priced at par with or at a discount to the corresponding AUDUSD vol quantity, particularly in longer tenors that are less subject to high-frequency flow distortions common in shorter expiries. But such are conditions today, caused by spot moves that have delivered market making option books longer of AUDJPY vega on previously traded Uridashi structures and in need of selling vol to flatten Greek profiles. We have no visibility on the degree of vega imbalance that still exists on option books and therefore the longevity of the ongoing AUDJPY vol softness; all one can say with some assurance is that the vol spread has historically been positively convex w.r.t. to overall risk conditions, and that odds of negative returns from buying the spread at current market are fairly slim judging from available history.
In practice, current liquidity conditions do not permit acceptable pricing on the FVA product that is the cleanest expression of fading this dislocation; investors need to be content with the muddier expression via 2Y vanilla ATM straddles that incur more realistic bid-offers.
Trade tips:
On hedging grounds, we advocated shorting AUDJPY futures contracts of mid-month tenors, as the underlying spot FX likely to target southwards below 64 levels in the medium run. Writers in a futures contract are expected to maintain margins in order to open and maintain a short futures position. Alternatively, ATM delta puts are suitable with a view of arresting potential downside risks (spot reference: 68.806 levels).
On trading grounds, buy AUDJPY vs AUDUSD 2Y ATM straddle spread @ 0.15/1.15 vol indicatively (mid 0.75v). Courtesy: JPM
