FxWirePro: G7 FX volatility ahead of contagious phase of tariff decision

It seems that both euro and the US dollar are in demand. A mixture of cautious sentiments towards the Emerging Markets, relief following positive comments on the part of the Italian Ministry of Finance about the Italian budget deficit and government debt, concerns about possible new US tariffs on Chinese products and uncertainty ahead of the ECB meeting on Thursday. But there is nothing concrete for an entirely new assessment of our view on EUR-USD and have no real answers. 

The comment period for the US administration’s plan to implement tariffs on another $200bn of imports from China ended on September 6th; if greenlighted, this would mark a significant escalation in trade tensions that have roiled markets for the better part of the year. 

It is difficult, if not impossible, to handicap the extent to which the escalation of tariff risks has already been discounted into battered EM asset prices; what can be said with more assurance is that a handful of assets that screen as fair or expensive vs the global growth cycle have not factored in a more disruptive, contagious phase of the trade war.

G7 FX volatility is one such cheap asset. VXY G7 is priced about 1 % pt. too low for the current level of Global manufacturing PMI, a 1 std. error mismatch (refer above chart). 

In contrast, VXY EM screens 3.5% pts. too high (+3.1 std. error) on similar metrics, highlighting the EM/DM vol gap that has opened up in the past few months. 

EUR and JPY are the two largest components of the VXY G7 basket and also the two biggest contributors to this cyclical cheapness. 

We have already discussed EUR vol / options in the context of Italian budget risks in recent publications (e.g. Option plays for CNY basket calm and Italy risks), the gist of which is that owning EUR puts/USD calls in various formats (6M 10D puts and/or EUR vs. gold 6M 25D put switch) is appealing given the combined low vol, flat curve and positive forward points. Courtesy: JPM

Currency Strength Index: FxWirePro's hourly EUR spot index is inching towards 4 levels (which is neutral), while hourly USD spot index was at 28 (mildly bullish) while articulating (at 09:48 GMT). For more details on the index, please refer below weblink:

http://www.fxwirepro.com/currencyindex