FxWirePro: Global central banks’ policy shift and frontiers on VXY valuations

The Fed was far from the only monetary policy game in town this week, and FX markets were as much driven by an ongoing repricing of BoE, policy rhetoric surprises in NOK, JPY, and to a lesser extent AUD. Rather than a dollar story oriented around the US cycle and policy, the main focus and driver of FX remains the broader set of monetary policy repricing (and in some cases lack thereof) which is more driving FX relative performance and pairwise outcomes. 

But some recent policy developments have come as somewhat idiosyncratic surprises, and thus recommend an approach that is less rigid on top-down or normative policy assessments, but which instead remains open minded to shifts in policy focus and reaction function, even if they seemingly violate earlier frameworks. The Fed played out to the hawkish end of our scenarios, and the USD has repriced appropriately in the past two weeks. But further pricing in of the 2018 dots and cyclical outperformance will require time and rely on inflation.

Event risks:

Australia: RBA Deputy Governor Debelle speaks on ‘Central Bank Independence in Retrospect’, 7:00 pm Sydney time.

Euro Area: Sep economic confidence, business climate indicator and final consumer sentiment are all released. Survey measures have continued to show positive businesses and households.

UK: BoE Governor Carney opens the BoE Independence Conference (Sep 28-29).

US: Q2 GDP 3rd estimate is expected to be unchanged at 3.0% annualised with a material revision unlikely. Fedspeak includes Vice Chair Fischeron ‘Developments in Central Banking’, Rosengren at Money Marketeers in NY, George on the economy and policy and Bostic on careers in economics.

We had anticipated the catalyst for moderate vol strength in the back half of the year to be a partial rebound in the dollar after H1’s relentless decline, but instead the trigger turned out to be further dollar weakness led by the Euro’s surge and leveraged investor interest to participate in the uptrend. Q3’s vol rally is therefore a typical in that in that it wasn’t accompanied by the usual souring of risk sentiment; as a result, the fruits of vol ownership were restricted to EUR and EUR-bloc currencies that benefitted from directional option demand, with little/no spillover to the wider high beta/EM FX complex (chart 1) that also faced the negative carry hurdle of upward sloping vol curves.

The characterization of vol developments matters because it shapes our forward looking outlook. Demand and supply of options from directional investors, the marginal driver of option prices over the past three months, is notoriously difficult to systematically track let alone forecast; a low conviction guess is that the marginal cooling of Euro-area data momentum in recent weeks and the post-FOMC dollar bounce will serve to tame broad-based USD put buying interest in coming weeks, especially in the context of a fairly heavy existing stock of USD shorts.

There could even be some vol supply from partial profit-taking and/or USD put overwriting on in-the-money cash dollar shorts as suggested in these pages last week. At the same time, (a) the knee-jerk spike in EURUSD implied vols this week once spot reversed its post-FOMC decline to re-test the 1.20 level speaks to the strong latent interest to still own the European reflation theme, and (b) any follow-through on this week’s USD strength will add to realized volatility via a shakeout of complacent dollar shorts as well as fresh demand for USD calls (e.g. USD calls/JPY puts post-FOMC), hence risks to a subdued short-term outlook for option demand are squarely to the upside.

The directional demand/supply outlook for options tilts in favor of higher FX vols, but the 2-vol+ cyclical undershoot on VXY from earlier in the year has corrected to a large extent. These offsets argue for a milder, more balanced bullish vol bias in Q4. Courtesy: JPM