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A dovish Fed is precipitating the fall in the USD despite the Fed hasn’t cancelled its tightening cycle but maintained dovish tone. The Fed cut its rate projections substantially again this week, again undermining the dollar versus every currency.
Among majors, USD/JPY slipped 0.12% to trade at 112.57, EUR/USD was up 0.25% at 1.1321 and GBP/USD has edged up about 0.15%.
In commodity currency segment, AUD/USD up 0.63% at 0.7674, NZD/USD rallied about 1.18% to a 5-month's high of 0.6931, and USD/CAD declined 0.57% to trade at 1.2998.
US dollar index, which measures the greenback’s strength against a trade-weighted basket of six major currencies, was down 0.29% at 94.89, the least since 18th March.
The breadth of the move, we find value in fading risk premia in USD risk-reversals to benefit from an extension of the move in the short term.
Although it may feel that one is late to the party in selling USD risk-reversals at current levels, the trade has merits on two accounts.
Firstly, chart showing spot vs 3m vols (chart 1) demonstrates that there is more room for implied skews to soften as a draw near to the most depressed spot-vol correlations in the business cycle.
Secondly, it is a well documented fact that USD risk-reversals embed a systematic risk premium above and beyond a fair value purely based on performance.
Consider chart showing risk premia (chart 2) as an illustration, this time gauging implied skews against the correlation between spot and realized vols. Most currencies lie in the top left quadrant of rich USD skews, where the premium for USD calls over puts is at odds with the fact that spot-vol correlations are negative.
Please be noted that the correlations between spot and realised vols considered are more in accordance with the actual experience of short dated risk-reversal trades, which are predicated on spot-dependent gamma performance.
While, in chart 1 dollar remains positive against certain pairs, these latter measures can be very negative for a number of pairs, and are currently only significantly positive for TRY, BRL and ZAR.
According to the chart the only USD RRs that may be considered too low are USD/JPY, and too a lesser extent, USD/CHF. Most currencies in the rich skew quadrant are fair game. In fact we hold short positions in USD/KRW and USD/INR skews.
