FxWirePro: Low vols and depressed risk reversals - Shorting EUR/CNH call to finance USD/CNH calls

If you are reckoning about a break in the dollar appreciation trend, then USD calls seem to be cheaper relative to spot retracement headroom in CNH, thus, we advise the best value in USD calls judging from the number of queries on the topic recently, real money investors are increasingly beginning to devote option premium to hedge against a continuation of the dollar rally.

What is worth noting is not even the fact that the FOMC minutes continue to sound cautious and that the Fed rate expectations eased slightly can harm the US currency. It is not the marginal changes in Fed expectations that cause USD optimism. Instead, it is likely to be the fact that the Fed is returning to what in economists slang is referred to as “active” monetary policy. USDCNH calls screen as the most attractive to own given the low vol base there, depressed risk-reversals and substantial daylight (>4%) between current levels and 4Q’17 spot highs. CNY weakness in the midst of US/China trade negotiations is not our baseline view, however, hence we like our old favorite of financing USDCNH calls on a zero-cost basis by selling EURCNH calls. The attraction of funding via EURCNH options is two-fold.

Primarily, EURCNH is not just any random EUR-cross; since the institution of the RMB basket mechanism in late 2015, EURCNH has acted as a loose (inverse) proxy for the CNY TWI itself given the meaningful (16%) weight of the Euro in the basket. If the CNY basket is stable this year, it stands to reason that upside in EURCNH should also be limited.

Secondarily, reasonable option premium can be collected from selling EUR calls/CNH puts due to negative points carry on both the EUR-and CNH-legs, which offsets some of the disadvantages of depressed EURCNH vols relative to USDCNH vols in an elevated USD-correlation environment.

A potential pushback against selling EURCNH calls is that a Euro surge of the kind seen in 3Q’17 could drag EURCNH higher even absent a USD revival; it is a fair critique, but one we judge is low probability at the moment since the unique initial conditions associated with that Euro move –a sizeable risk premium in the currency coming out of the French election non-event, clean spec positions and the surprise/shock effect of the Draghi’s hawkish policy turn at Sintra – are no longer present. Courtesy: JPM

Currency Strength Index: FxWirePro's hourly USD spot index is flashing -15 (which is neutral) ahead of FOMC members Dudley and Bostic’s speeches, unemployment claims while articulating (at 08:16 GMT). For more details on the index, please refer below weblink:

http://www.fxwirepro.com/currencyindex.

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