FX markets are seeing cracks.
As we highlighted last week, the USD/JPY, GBP/USD and gold experienced
significant breaks on 3-4 October. The EUR/USD (and USD/CHF) break on
the downside happened later, the move taking place this week on 11
October, confirming the dollar index’s upward break the day before.
Within its wide 1.05-1.16 range, EUR/USD had been diligently following a
bullish trend since last December, but this is no longer the case, as
it pierced the line below 1.1130 (Graph 1). As we write, themarket eyes
the supports at 1.0820 and 1.0530.
The main theme is that a sustained wave a dollar strength is related to hawkish vibes from the Fed. The
euro move happened just ahead of the FOMC minutes, which revealed
that the case for a September hike was a “close call”, and our
economists still view that the Fed is on track for moving in December.
Interestingly, the euro bullish trend started exactly when the Fed
increased rates last year. The board prepared the market for the
tightening after summer 2015, and EUR/USD collapsed from 1.15 to 1.05.
It reached its low point about two weeks before the first hike in
mid-December 2015, when the ECB delivered an unconvincing package (the
market hoped for more QE) triggering the bounce of early December. The
Fed hike was already fully priced in, and the market subsequently
unwound its dollar longs ahead of the meeting. We are now two months
ahead of the December 2016 meeting, and there is still a decent 30%
probability that the Fed will stay on hold, while the hike-implied
probability has not been shaken by the minutes. There is still
uncertainty about the Fed timing, which could easily fuel the ongoing
leg of dollar appreciation.
The analysis suggests EUR/USD bearish option trades ahead of the December Fed. As
the market will become increasingly worried about the next hike, the
S&P should be more vulnerable and more turbulent (as per the
negative correlation between stocks and their volatility). UST yields
have a strong negative correlation with US equities, which implies
higher S&P volatility. According to our model, this leads to a lower
Selling the bottom of the range: Instead
of targeting the exact level where the EUR/USD will trade in two months
in a bearish scenario, we trade a sub-range, namely the portion of the
full range below 1.08.
This can be implanted by buying a 2m Digital European put with a strike at 1.0750 and KO at 1.0450.