FX Compass

The odd couple

FIG 1 - FX Vol subsided even as the USD rebound in Feb Last week's US core PCE data surprised us with an upside surprise, prompting me to expect a further increase in US terminal rate expectations and consequently, the strength of the USD. This has resulted in an especially strong performance of the USD against currencies such as JPY, which have been lagging in rates. On the other hand, the move has been more subdued against currencies like EUR and GBP, where rates are re-pricing higher. Interestingly, this USD strength is being accompanied by lower implied volatility, which is an unusual occurrence, even in the face of adverse data surprises.

When I last took profits on a long EURUSD position at 1.0950, I had argued that I would look for a move towards 1.0600 to re-establish a new long position. However, despite being below that level, I do not see sufficient risk-return benefits for executing the trade given the much-changed dynamics on the US side. I suspect that the market is intent on testing the 2023 lows just below our Q1 range extreme at 1.0500, and I prefer to wait this process out before engaging.

With regards to USDJPY, the likely new BOJ governor Ueda's parliamentary hearings have thus far seen him playing it safe and making no suggestions that the current monetary policy stance is either inappropriate or about to change. However, USDJPY 25-delta risk reversal skews are again moving in favour of OTM JPY calls, even as spot moves higher and implied volatility falls. I suspect that some players feel that optionality on another BOJ hawkish surprise is worth owning now, whether that be a surprise final YCC shift by Kuroda at his last meeting on 10 Mar or an out-of-the-blocks aggressive call by Ueda at his first meeting on 28 Apr.

In this FX Compass, I also look at the pro-cyclical G10 FX, CNH, KRW, and CLP. In the pro-cyclical G10 space, I hold on to my long positions in AUDNZD and in NOKSEK, targeting 1.1200 and 1.0700, respectively. In Asia FX, I take profit on my short KRWIDR trade idea and revise my USDKRW forecast range higher to 1,275-1,350 (from 1,215-1,285). I also revise my USDCNH forecast to 6.70-7.10 (from 6.65-7.00). Lastly, in Latin America, I continue to see the 770-880 target range for USDCLP as appropriate.

Macro Overview

The odd couple

The recent US core PCE upside surprise prompted another leg higher in US terminal rate expectations and further strength in the USD, and as an individual, I believe this trend will continue. The USD has been performing exceptionally well against currencies such as JPY, which are lagging in rates, and where outdated long positioning has become an issue. However, the move against currencies like EUR, GBP, and MXN has been more subdued, with the latter actually seeing the greenback losing ground due to higher rates and near-shoring narratives. This dispersion indicates a phase of benign USD strength, despite high inflation prints challenging comfortable market narratives about "immaculate disinflation."

This calm in the markets is visible in indicators like the VIX, which has returned to around 20 after 3 highs near 24 last Friday. Additionally, 2-month EURUSD implied volatility is closing in on lows for the year at 7.7%, even as the market ramps up US terminal rate pricing to the point of pricing in some odds of a 50bp rate hike at the 23 Mar FOMC. This trend is interesting and surprising, given historical cases of "risk off" episodes when comfortable rate profiles become challenged. It can be linked to encouraging recent news about underlying economic growth and equity earnings outlook, which were not as dire as expected, but it still remains somewhat puzzling.

Regarding core FX directionally, starting with EURUSD, German 10-year yields around 2.65% are now at the highest level since June 2011, reacting to the rise in implied terminal rates to close to 4.00% by Q3. Strong French and Spanish preliminary Feb CPI numbers contributed to this move, and the market is now waiting for tomorrow's euro area number. With ECB chief economist Lane saying that rates may need to stay high for a "fair number of quarters," the market has also taken out the inversion between Sep'23 and Sep'24 implied Euribor rates that was priced in at the start of Feb and now has a positive spread again. However, the 5y5y euro area inflation swap is at 11-year highs, suggesting more work lies ahead.

FIG 2 - The Euribor strip has priced out H124 cuts the SOFR curve has not yet FIG 3 - The USD’s rate advantage vs EUR may The passage discusses the recent USD strength against currencies such as JPY and EUR due to US terminal rate expectations and high inflation prints challenging market narratives about disinflation. However, USD strength against MXN is still losing ground due to higher rates and near-shoring narratives. Despite the market ramping up US terminal rate pricing, indicators like the VIX and 2-month EURUSD implied volatility are calm, which is surprising given historical cases of "risk off" episodes. The passage then analyzes the directionality for core FX, noting that EURUSD is struggling despite rising levels of rates support. The Sep '23 vs Sep '24 SOFR strip inversion is reduced but still has room to dissipate, potentially leaving space for more USD support. The author does not see sufficient risk-return benefits for executing a long EURUSD position and suspects the market is intent on testing 2023 lows just below 1.0500. The passage also mentions asymmetric risk from tomorrow's euro area preliminary CPI number, which may not necessarily help if the ECB doesn't validate it with more hikes or if there is a weak number, which would likely weigh on EUR.

FIG 4 - The spotlight in JPY is on the upcoming 9-10 FIG 5 - Falling vol and rising demand for USDJPY JPY: Market back to seeing appreciation as the tail event

The current outlook for USDJPY remains relatively positive, with the likely new BOJ governor Ueda taking a cautious approach and not suggesting any major changes to the current monetary policy stance. This has resulted in markets returning to the psychology of Q2/Q3 2022, with JPY losing ground against other currencies such as USD. Although Japan economics does not disagree that it may take until June or beyond for meaningful changes to the YCC framework to arise, it is worth noting that Japanese policymakers have surprised markets in the past 5 months with aggressive FX intervention and widening the YCC band to +/- 50bp.

This track record of unexpected policy moves may explain why the USDJPY 25-delta risk reversal skew is moving in favor of OTM JPY calls, as some players feel that optionality on another BOJ hawkish surprise is worth owning now. The author continues to hold a 6 Apr '22 USDJPY put with a 130 strike, which would perform best if Kuroda were to pull the trigger on 10 Mar. However, they are not yet interested in entering short USDJPY spot trades due to negative carry and the absence of a likely near-term catalyst for a reversal. Overall, the point is that USDJPY spot levels and sentiment are now at levels where option trades can be owned as an acceptable risk/return tail trade, rather than a core view with a very narrow path to a profitable end outcome.

GBP: Smelling the coffee, finally

UK PM Sunak has reached an agreement with the EU on an updated NI Protocol called the Windsor Framework, which signals a turn in sentiment towards cooperation with the EU. This is likely to improve UK economic performance, especially in terms of exports and investment prospects. While this does not immediately signal a need for GBP to surge higher, it does provide a fresh tailwind at a time when markets in general continue to favour short GBP positions. The SONIA strip has not missed out on the general re-rating of global rates higher over the past week, helped by strong UK data such as the release of buoyant Feb preliminary composite PMI data. Three more 25bp rate hikes are now priced in over the next 4 meetings. The authors of this piece have argued for selling rallies above 0.8900 in EURGBP with a target of 0.8700 achievable in this quarter. They have now lowered stop losses to 0.8840, with a take profit target of 0.8700.

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