FxWirePro: “Euro strength or perhaps dollar weakness?” Bid EUR/USD and 10y USD ATMS dual digitals as Euro’s next phase of recovery looming

Are you puzzled by “Euro strength or perhaps dollar weakness instead?” “Was the latest FX move due to Sterling?” The fair elucidation of the exchange rates would always be challenging.

Despite robust growth, the ECB would likely remain vigilant and is unlikely to start raising interest rates before the end of 2019, since core inflation will remain very low for a long time to come and will require an expansionary monetary policy. The Fed, on the other hand, will continue the interest rate hike cycle in 2018 and raise the key rate three times. The different monetary policies suggest a moderately stronger USD against the euro. Only in the course of 2019, when the ECB's first interest rate hikes are foreseeable and the Fed's hiking cycle is approaching its end, will the euro be able to recover against the USD.

The ECB’s very accommodative monetary policy has fuelled a clear acceleration in Eurozone growth. At this stage, anything that revives the ECB policy normalization debate will now support the euro.

Our bearish dollar view owes less to US expectations than it does to expectations that the recovery in Europe/Japan is here to stay.

There are a lot of stale euro longs to get through, but euro bulls eventually should be rewarded with the help of strong economic data, and now optimism that a coalition government can be formed in Germany. We consequently expect the EURUSD to continue to unwind its undervaluation.

Buy 6m European dual digital: EURUSD > 1.2350, USD 10y CMS > ATMF+10bp Indicative offer: 12% (USD notional, EURUSD: 1.1860, USD 10y forward: 2.45%).

Take benefit of FX/rates correlation EURUSD mostly needs EUR yields. The EURUSD is showing strength despite unhelpful relative yields, and we expect it to break free higher even without their joint support.

Specifically, with more uncertainty surrounding ECB normalization than the Fed’s tightening cycle, implying more room for European yields to grind higher, the next leg of the EURUSD recovery should be driven more by EUR rates than USD rates. With the correlation between the EURUSD and USD 10y rates negative (-30% the past six months), a dual digital payoff requiring both of them to move up should cheapen.

Risks: limited to the extent premium paid

FX and rate underlying spots must both be above their respective strikes at expiry to get the final payoff. Otherwise, the option expires worthless.