FxWirePro: A glimpse through cheap and leveraged USD hedges

The yield of 10-year US Treasuries flirted with the 3% mark again yesterday and immediately all the usual suspects (BRL, MXN, RUB, INR, ZAR and TRY) came under depreciation pressure again.

However, a part of the recent depreciation of EM currencies is also likely to be due to the excessive optimism is seen over the past few months: in view of a lack of other alternatives, EM investments were in high demand. A strong rise in US yields still bears the risk of triggering a far-reaching round of EM depreciation.

However, as EM current account deficits are much lower - compared with the crisis in 2013 - and in view of the much more stability-orientated EM central bank policies, we are confident that this remains a risk scenario.

The question around the longevity of the ongoing USD rally remains. The base case YE scenario is for a 1.5% narrowly bearish USD path to YE.

Admittedly, IMM positioning indicates the USD shorts at around USD26bn (more than 2 sigmas below 1-year average) to be the widest since Aug 2011, posing a notable risk from unwinds (part of which likely already played out in the recent 1.9% USD TWI move). Absent a high conviction into a sustained USD rally we opt for looking for short tenor, cheap, leveraged USD hedges.

1st chart (RHS) compares individual short tenor USD topside at-expiry digitals across EM and high beta G10. SGD, HUF, PLN, KRW and NZD screen as the best value based on the current spot-barrier distance (all strikes are set in such way that the digitals price at 20%, i.e. project 5:1 payout).

Over the past week, the USD already strengthened against all five, the most so against NZD and PLN, 3% and 2% respectively. 2M 1.3500 strike USDSGD AED call costs 19.5% (after 3% stealth) spot ref 1.3254. USDSGD was at 1.3500last Dec before the dollar slump.

Considering that if the USD bounce resumes it is likely to be broad-based, mimicking the price action from the last few days, and to gain leverage we turn to a basket approach. Baskets aim to benefit from implied correlations that are in the middle of the historical 40-60% range and still having room to reprice higher – a process that has already started.

In the 2nd chart, it displays some of the more attractively priced 2M worst-of basket USD/high beta ATMS calls that offer solid correlation savings (50% vis-à-vis cheaper vanilla, after accounting for a 20bp USD transaction cost charge). Combinations involving SGD and TWD appear the most frequently. CLP and CAD are the other two prevalent currencies.

These low-cost instruments are worth considering as leveraged hedges against a protracted broad-based USD move or to lever up vanilla or cash positions. Courtesy: JPM

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