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Both shocks this week – an insufficiently dovish Powell and the re-escalation of tariffs – reinforce a defensive stance of favoring safe currencies and the dollar against high-beta FX. A sudden tariff escalation suggests another round of sentiment and forecast downgrades just as the set of downgrades from May were settling down. The door for pricing a substantial Fed easing cycle has blown open again a mere 24 hours after Powell had nearly shut it down, but we do not see this to be dollar-bearish under present circumstances. So long as Fed dovishness is primarily driven by global risks, rest-of-world weakness and the dollar’s anti-cyclical characteristics will keep it well supported.
The cynical element of this whole constellation is: the risks that arise from the global trade conflict began by President Trump would imply that the central banks worldwide are becoming more expansionary, including the Fed. After all, the tougher Trump seems in the conflict with China, the higher the risks for the US economy and the sooner and quicker the Fed will cut interest rates. Finally, both of the week's events put the spotlight back on US FX intervention risk.
The late-summer bullish seasonality of FX vol has returned with a vengeance after a hawkish Fed cut and unexpected resumption of trade hostilities.
USD call spreads/digitals in CNH offer the best value as clean, defined premium expressions of escalation of the trade conflict. Alternatively, open a basket of long USD calls in North Asia financed by USD calls/INR puts as a relative value expression of North Asian FX underperformance vs. South Asian FX.
GBPUSD could go sub-1.15 in No-Deal Brexit, but options markets are pricing only 15% probability of such an outcome. The tail risk can be hedged via 6M GBPJPY – GBPAUD vol spreads. With forward vols, undershooting spot vol by 2pts the risk-reward in 4M in 4M-type FVAs looks attractive. Courtesy: JPM & Commerzbank
