Executive summary

In this report, Rich looks for opportunities in the foreign currency market among continuing conversations about the U.S. debt ceiling as a possible catalyst.

Last year may be considered more of a “macro” year vs. the previous year in which the cheap cost of capital was driving risk taking across many asset classes. We can see this most clearly when we compare the measures of risk across various asset classes. For this exercise, I looked at the JPM VXY global FX implied volatility index, the VIX Index for stocks, the MOVE Index for bonds, and credit spreads as calculated by the Moody’s Corporate Baa yield vs. Treasuries. These measures of risk historically move together, leading many to refer to the risk-on/risk-off type of nature to markets. However, in all of 2022 – despite heightened measures of risk in FX and U.S. sovereign bond markets, the more macro markets, and the measures of risk in the idiosyncratic – single securities markets of equities and credit did NOT see any meaningful uplift in levels. These measures do not stay disconnected for long, and we are beginning to see the macro measures start to move lower, potentially looking to re-align with the sanguine views in the idiosyncratic markets.

Image 1: JPM G7 implied volatility index compared to VIX, MOVE and credit spreads

It is somewhat interesting to see these macro markets showing a decline in implied volatility right before we have perhaps one of the bigger macro catalysts of the year – the U.S. debt ceiling standoff. However, there are other drivers of FX rates that we should perhaps consider trying to understand what is driving the flows. One of the first I like to look toward are the interest rate differentials. I use the 10-year yield spreads because this is the more “investable” part of the curve where I believe sovereign wealth funds, insurers, and reserve managers tend to focus. If we compare the spread between Bunds and Bonds to gauge European vs. U.S. levels, or the spread between Bonds and Japanese Government Bonds (JGBs), we can compare to the broad Dollar Index (DXY) so get a sense if there are any dislocations. On this front, the DXY does stand out vis a vis European vs. U.S. bond spreads but not compared to U.S. vs. Japanese spreads.

Image 2: European and Japanese government bond yields vs. U.S. bond yields compared to DXY

We can see this on display using the CVOL tool as well. In this graph, I look not only at the overall index of CVOL for the G5 currency pairs, but I can also plot on here the at-the-money (ATM) volatilities, skew and convexity. I can hardly tell the difference between the CVOL and ATM, which tells me that the out of the money (OTM) volatilities may not have a big influence on the index. We see this with the convexity chart in green at very subdued levels suggesting OTM options may be the best value. Finally, the skew index has oscillated around 0 and currently sits there, suggesting there is no strong preference for calls or puts across all the main currencies in aggregate.

Image 3: CVOL Index, skew, convexity and ATM volatilities for the G5 currencies

I want to drill in more closely, again looking at the interest rate spreads and the more direct currency pair. Sure enough, U.S. vs. JGB interest rate spreads compared to USD/JPY show little dislocation if any, suggesting there may be no imminent trade in this currency pair.

Image 4: Japanese Government Bond (JGB) vs. U.S. Bond compared to USD/JPY

Doing the same comparison with Bunds vs. Bonds and EUR/USD, there seems to be more of a disconnect. I use Bunds vs. Bonds knowing full well there are other countries in Europe to consider. However, my sense is the Bund market is the anchor market and the most liquid market, thus the “real” money will focus more here. Looking at this spread, it may suggest that there could be some upside potential in the EUR/USD currency pair. This may be lining up like the dislocation in 2018 that resolved but took quite some time to do so.

Image 5: Bund vs. Bond yield spread compared to EUR/USD

Considering all the major FX pairs, I also look at UK Government Bonds (Gilts) vs. U.S. Bonds and compare them to the GBP/USD rate. On this front, GBP looks a little overvalued using just this one simple metric.

Image 6: UK vs. U.S.: Gilt vs. Bond yield spread compared to GBP/USD

For China, I like to look at a couple different measures given the high growth nature of China. For me, money flows into China when there is the sense that relative measures of growth will be higher in China vis a vis the U.S. Given the capital controls, the simple interest rate differentials don’t play as much of an effect. However, when growth is expected to be much higher, capital will flow into China and vice versa. Some of the narrative around China was about the reopening trade. We can see that in the back half of 2022 and early 2023 when we compare the PMI levels in each country. Interestingly, the currency did not respond and perhaps this is because the stock market did not respond. When we look at the relative performance of the SHCOMP vs. SPX in purple, Chinese stocks have not moved much. Thus, money was not flowing into China as much as might be expected.

This is particularly interesting given the narrative around the de-dollarization in global markets. With China, Russia, and others pricing trade in RMB instead of dollars, there is a growing sense that perhaps the dollar will lose its hegemony. This would be a major trend change and something worth considering. There are no major signs of this yet but it is something to keep in mind.

Image 7: China vs. U.S.: relative PMI (white), relative stock performance (purple), currency (blue)

Now we layer into this the U.S. debt ceiling stand-off. The latest estimates for the “drop-dead date” are June 1 by Secretary Yellen and June 2 by others who are tracking the amount of money in the Treasury General Account. While there still seems to be a consensus that this stand-off will be resolved in the eleventh hour as it has been in the past, there are some signs that the market is not as hopeful.

If we look at the spread of 1-month vs. 3-month bills, we can see a spike in the relative yields over the past couple of months, when the 1 month was before the drop-dead date and 3 month was after. However, now that 1 month includes the drop-dead date, this spread has collapsed.  People are looking for a yield premium if they are holding paper around the drop-dead date.

In addition, we can look at the U.S. credit default swap market. This line, in blue below, has shown spikes around previous debt ceiling wobbles in July 2011 and January of 2013. However, the move in CDS levels is more than double the spikes we saw at that time, with CDS levels now almost 178 bps. Previous highs were less than 80 bps. As I said, the market does not seem as sanguine this time.

Image 8: U.S. 1-month vs. 3-month T-bill yields and U.S. 1-year credit default swaps

It’s the biggest holders of U.S. debt that may be the most concerned. The Japanese are the biggest holders of U.S. Treasury bonds, followed by the Chinese, and then the UK. The UK numbers most likely are international fund managers with offices in the UK.

The question then becomes, what would the Japanese or Chinese do if they become nervous around this event? To the extent this bucket of risk is in search of higher yield than domestic markets provide, these investors may look to move more into European bond markets.

Image 9: Major international holders of U.S. government debt

If we look at the performance of the major currency pairs in the previous debt ceiling events, we can see that all major currencies moved together, with the biggest movers being EUR and CNY.

Image 10: Price moves for the major currency pairs around previous debt ceiling stand-offs

Another consideration is the outlook for the relative performance of asset markets. In this chart, I show a 20-year history of the Dollar Index (DXY) and compare it to the relative performance of emerging market stocks vs. U.S. stocks (called EEM vs. SPY here) or other developed market stocks vs. U.S. stocks (called EFA vs. SPY here).

We can see when the dollar is trending stronger, it coincides with U.S. stock outperformance vs. the rest of the world. Conversely, when the dollar is trending weaker, it coincides with global stock outperformance vs. the U.S. So far this year, even though the dollar has pulled back some, we are not seeing the global stock outperformance yet. Perhaps this is an opportunity.

Image 11: U.S. dollar compared to the relative performance of EFA vs. SPY and EEM vs. SPY

The last step I take is to look at the level of implied volatility in the various FX markets to see if any of them stand out vs. the others. We saw in the first chart that the general level of implied volatility had come lower, but was this in certain currency pairs?

In fact, if we look at the level of volatility using the CME Group CVOL tool, we can see almost all currency pairs are at one-year low levels of volatility, suggesting that perhaps long options ideas are not a bad thought.

Image 12: CVOL tool for FX options

I want to focus on the EUR/USD currency pair. For one, I don’t notice a big dislocation vs. interest rates in JPY. I know the Japanese are the biggest holders of U.S. debt, but even in previous episodes, the JPY was not the biggest mover. Second, I thought to look to the RMB or CNH market for bullish ideas. However, there is not as much liquidity in these markets yet for me to express those views. Finally, I think with the EUR, there is a dislocation vs. interest rate markets, and we have seen flows into EUR in previous episodes. Thus, I think I could have positive drift higher even if this is resolved in the eleventh hour, and if not, there is a catalyst for an even faster move.

When I drill into the EUR/USD options market, I see that the skew for the calls is below both the puts and the at-the-money options. I am looking at the weekly EUR options that expire on June 2. I find this to be very interesting and for me, see this as an opportunity.

Image 13: Implied volatility skew for June 2 weekly options

To put on a long EUR idea while taking advantage of the skew, I look to buy June 2, 1.1025 calls. I defray the cost of these options by selling a 1.08-1.0650 put spread. Thus, my risk is limited on the downside, but I have unlimited upside should EUR move higher.

Those who would prefer to not have the downside risk from the short put spread and want to lean into the implied volatility market being at one-year lows could choose to just buy the 1.1025 calls outright. We can see the implied volatility of about 6.9 is below that of both put options. At 6.9, we are below the levels as seen on the CVOL tool as well over the last year. Thus, we are getting into long options at a good level.

The graph of expected return as well as the Greeks for this idea are below.

Image 14: Expected return of a short EUR put spread, long call strategy

If I am looking to tactically trade when approaching a catalyst, I want to have more going for the idea than just the one market-moving event that everyone is aware of. This is not to say that this debt ceiling stand-off won’t be a catalyst, but when combined with other reasons to own, I have more than one way to win. When I look at the other currency pairs based on relative growth, interest rate differentials, or previous performance in the debt ceiling events, I do not see the same opportunity as I do with EUR/USD.

This may resolve and prove to be a nonevent. If not, I feel like this option idea gives me protection against a big possible event, but also gets me into a long EUR idea that I would like, nonetheless.

Good luck trading.

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