FX Quant Strategy provides a quantitative overview of the currency market, including several valuation tools and monitors, focusing on the FX options market.
This week we recommend one FX option trade: buy 1M 111.00-108.50 USD/JPY put spread.
Implied FX volatility has declined significantly following the first round of the French presidential election. As such, the risk premium related to t he political situation in France has been completely priced out and implied FX volatility generally trade in neutral to cheap territory across the major and Scandi FX universe and across tenors.
As argued in Strategy: Focus on economics again (sort of) , 28 April, we see evidence that the global business cycle is rolling over and growth seems to be decelerating in the US. In this environment, we typically (historically) see implied FX volatility become more volatile with a tendency to spike higher. In this respect, we note that 12M USD/SEK implied volatility is currently cheap (so is 12M EUR/USD). Hence, investors who expect a decline in global equity prices should consider buying a 1Y USD/SEK call option, which offers an attractive relationship between beta (FX spot versus equity prices) and the FX option price.
Moreover, we note that implied GBP volatility trades neutral relative to the rest of the G10 universe. We expect risk premium to increase as the UK election day approaches and we expect implied GBP volatility to increase relative to the rest of the G10 in the coming month. EUR/GBP and GBP/USD risk reversals at the 1-3M tenors also trade in neutral territory and close to zero in absolute levels. We would look to buy 1M or 2M EUR/GBP put spreads if spot bounces up to 0.85 (provided risk premium is still not priced in FX volatility).
Looking at the signals from our short-term financial models, we currently observe some very stretched misalignments in the Scandi FX crosses. In particular, the NOK is very oversold vis-à-vis the EUR, USD and SEK, according to the models. However, as argued in NOK Flash Comment: Externals beating domestics, tactical caution advised (3 May), we see no obvious trigger for NOK revival in the near term and we stay tactically cautious on the NOK. The commodity currencies AUD, NZD and CAD are also oversold, according to the model. However, with the single-largest commodity consumer (China) showing weakness, we would not trade against this.
In the majors, USD/JPY is overbought according to the short-term financial model. Also, the cross looks less stretched from a technical point of view. On a one- to three-months horizon, we see little prospect of a sustained rally in USD/JPY from here, as in the current cyclical environment we see little risk of a significant sell-off in 10Y US (key driver of the cross) and as 'Tumpflation' is losing steam. With cheap implied volatility and negative (cheap) risk reversal, we recommend buying a 1M USD/JPY 111-108.50 put spread.
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