Derivatives Strategy: What If Both EUR/USD and USD/JPY Go Down?
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Our latest forecasts embed a moderately bullish dollar view for the coming months, implying that the standard negative correlation between EUR/USD and USD/JPY will prevail.
However, the negativity of this correlation is not bullet-proof: triggered by the Brexit vote, we saw an aggressive sell-off in the volatility space. We suspected that this would happen, regardless of the outcome, given the massive positioning in terms of hedges. Although risk-on conditions currently prevail and we favour risk-friendly spot trades (long GBP/JPY, short EUR/SEK), investors should be aware that the relief phase could be short-lived and see an abrupt end in a few weeks.
EUR to possibly come under renewed pressure... The Italian banking sector is in the eye of the storm, and our Fixed Income strategists fear that another half-hearted ‘solution’ is in the pipeline. Stress in peripheral credit risk would clearly weigh on the euro. Moreover, the UK has been the main source of negative risk sentiment and still is. Though BoE easing is already priced in, it may not appease markets and a new wave of turbulence may arise if discussions about Article 50 activation heat up. .
.. while the JPY would be bid Investors did not miss the opportunity to again select the yen as their currency of choice during the recent market jitters. USD/JPY has bounced above 104 and could appreciate more while the relief phase continues. If risk sentiment sharply deteriorates again, there will be more room at the bottom, as the pair tested 100 this month. The past incursions of the correlation between EUR/USD and USD/JPY into positive territory did not last very long but were nonetheless lengthier than the current spike. This could signal an unexpected market move that we would recommend trading via options.
Recommendation Buy 2m basket put on EUR/USD and USD/JPY, with a strike 1% OTM
Trade risks: Limited to the premium. Investors buying a basket option cannot lose more than the premium initially invested. Such an option will expire in the money only if the average performance of EUR/USD and USD/JPY in two months exceeds 1% plus the premium.
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