FxWirePro: Bid bullion OTC market projections and hedge yellow metal via 3-way straddle ahead of US non-farm and Fed’s approach over rates in 2018

The gold prices surged back to $1,325.96 levels but was unable to sustain 4-months highs as we have the US nonfarm payrolls on data front, this has been vital for the precious metal and a reading of 190,000 new jobs added in December expected today, yellow metal price has usually been sensitive to moves higher in both UST yields as well as the US dollar, the bullish dollar leads bullion market costlier for holders of foreign currency while a rise in U.S. rates, lift the opportunity cost of holding non-yielding assets such as bullion.

The Fed’s this month’s meeting decision is almost in lines of consensus. Do you think the shift in dynamics this time around is due to the improved growth prospects on account of tax changes and market’s expectations for fewer rate hikes next year?

Gold prices are sensing under pressure amid investor apprehensions over upbeat US economic data could strengthen the case for the Fed to raise rates more than currently priced in.

While we roll short to Feb’18 CME gold, short in gold since September 20 has been encouraged owing to the view that the market remained under-pricing Fed tightening, given solid economic growth and a possible bottoming out in inflation. Some repricing has already taken place.

In early September, the rate markets priced no hikes through 2018, during November just over two hikes (55 bps) were priced in. On Wednesday, Dec 13, the Fed elected to raise the Federal Funds Target rate by 25 bp to 1.25-1.50% while maintaining an outlook for three more hikes next year.

The JPM base case is that incoming Chair Powell will hike in March followed by three more hikes in 2018. As the market is currently pricing in around a 66% chance for a hike in March, we believe gold will continue to reprice lower over the next couple of months and stay short.

As you can see 6m IV skews have been well balanced, this signifies the hedgers’ interests on both OTM call and put strikes. While risk reversals have been indicating upside risks, using three-leg strategy would be a smart move to reduce hedging cost.

While it is reckoned that as per the OTC indications as shown above and the prevailing trend in bullion markets seem to be reasonably addressed by hedging participants, thus, we advocate below option strategy to keep uncertainty in spot gold prices on the check. On trading perspective also, the strategy likely to fetch positive cash flows regardless of underlying price swings with more potential on the downside and with cost-effectiveness.

Risk-averse traders who are uncertain about trend directions, go long in XAUUSD 3M at the money -0.49 delta put, and go long 6M at the money +0.51 delta call and simultaneously, Short 1m (1%) out of the money puts. Thereby, we favor bulls as we foresee more upside risks by keeping longer tenors on call leg.