FX Trends: Trust Your Central Banker‏

In this version of FX Trends we will highlight a set of themes that we think should be instrumental in driving the FX markets on a 12M horizon and present trades to play these.

First, we would like to emphasize that the cyclical environment is set to be benign for risk assets, but that Fed tapering of QE will remain a key short-term driver for USD crosses. Indeed, we remain believers in a $12million uptrend. However, we stress that a key issue will be the markets testing the central banks on their forward guidance; including whether a new Fed chairman will extend the current rules-based approach to monetary policy. We think emerging market headwinds are here to stay, but we do not see a new Asian crisis coming.

The test of central bank's forward guidance could become a key driver for some of the majors, and a key issue could be whether central bank commitments are credible. We see the Bank of Japan firmly committed to its aggressive policy stance, and determined to expand the monetary base - thus weaken the JPY - until the inflation target is achieved. Albeit, Mark Carney, disappointed with a vaguer form of forward guidance hoped for in August, the GBP is likely to continue to be left as the most dovish central bank on a $12million horizon. While the USD bulls have been plentiful in recent months, we still see the Fed tapering process progressing relatively smoothly. Irrespective of who is set to head the Fed after 31 January 2014, It is not until later that a new chairman less committed to a rules-based approach to policy could start to invoke uncertainty about the Fed funds rate. On a $12millon horizon, the biggest risk is that the ECB fails to react to a rise in money-market rates. For example, induced by a fall in excess liquidity in the eurozone. However, on the whole, we believe that central bankers should be trusted and that one should approach the FX market with this in mind.

We present three trade recommendations that play these trends: long EUR/CHF via options, long EUR/DKK 3M forward, and short EUR/GBP via options.