FxWirePro: Correlation Trades via Optionality for Dovish Fed

DXY has been buoyed by the US Federal Reserve’s more dovish approach in last monetary policy decision (where fed’s funds' interest rates were left unchanged at 2.50%). The Fed continued to preach “patience” and notably removed reference to gradually higher rates, an acknowledgment that the next move could be lower. It also said it will be flexible in its balance sheet rundown.

We look for short correlation trades as a way to express the lack of a tangible momentum in the currency space. The DXY index has remained in a very tight range (95-97.5) since last October, and now (at 96.4) is roughly in the middle of that range. 

While a dovish Fed has weighed on the US Dollar in the first week of January, the greenback has recouped some of its earlier losses over the past two weeks. 

At the moment, trend-indicators for the USD, either obtained from FX spot time series or from rates curves, fail to define a clear, short-dated outlook on Dollar-crosses, by possibly excluding GBPUSD (see for instance Cutting through the Brexit fog with cable risk reversals and GBPJPY – USDJPY call spreads). 

If ever, Mario Draghi’s comments yesterday could support an extension of the latest Dollar’s strength.

The dovish Fed has been a major catalyst for a substantial decline of market volatilities, with the VIX dropping to sub-20 levels after reaching a 1-year high of 37 on Christmas Eve. Both G7 and EM FX vols dropped steadily this January, with the DM/EM vol spread now nearing 8-months lows. 

Long EMFX Carry trade positions are performing decently well, supported by reasonable levels of carry-to- vol ratios (spurious proxies of implied Sharpe ratios) and mechanically lifted by the lower market volatility levels, rather than by an outright positive outlook on the EM asset class as a whole.

Still, identifying Carry-positive trades with a slight risk-off tilt could prove convenient given the relatively unexciting prospects on global growth and the numerous hurdles (US/China trade negotiations, US government shutdown, and Brexit process, amongst others) along the way before a full risk-on mode is embraced by markets. Courtesy: JPM

Currency Strength Index: FxWirePro's hourly EUR  spot index was at 8 (neutral), USD is at -56 (bearish), at press time 13:31 GMT. 

For more details on the index, please refer below weblink: http://www.fxwirepro.com/currencyindex