FX Markets Weekly: Impact Of Fiscal Tightening

FX Markets Weekly: The FX Impact Of Massive Fiscal Tightening

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FX Outlook: The FX impact of massive fiscal tightening
Whether Greece borrows from the EU/IMF or pursues debt restructuring, it will still need to undertake one of the greatest deficit reductions in OECD history. Major fiscal tightenings typically are currency-bearish, by an average of 5% real trade weighted and 20% nominal. Europe’s case in 2010 is unique since only a fraction of the region needs to tighten soon. The resulting euro depreciation should be less than the norm, but only if the EU/IMF facility addresses credit stress created by monetary union. Given implementation risks, increase euro shorts on the crosses.

FX Derivatives
Vols continue to trickle lower -- stay short vega and buy gamma opportunistically to create curve flatteners. 6M-1Y no touch trades in high beta FX pairs, with barriers struck in the anti-risk direction, earn carry passively along vol surfaces with predefined risk. With carry being the primary driver of P/L in long-dated USD/JPY option positions and spot that is range-bound, 3Y-5Y 40D-50D USD calls/JPY puts are the most carry-efficient strikes to own.

Trade Recommendations
Global reflation remains on course. This is a USD negative but only against currencies where the growth lift is most compelling and capital flows strongest (commodity FX/Asia). Favor longs in commodity currencies (switch short NZD/CAD into short USD/CAD, hold long CAD/JPY) and Asia (buy IDR vs EUR as a high-yielding, pro-growth, CNY-reval proxy). Add short EUR/CHF in cash to existing CHF longs versus EUR and GBP in options – Swiss revaluation fundamentals rival China’s without the political drama. Stay long NOK/SEK ahead of the Riksbank next week and continue to monetize a pre-election risk-premium in GBP via a short vol position in GBP/USD vs USD/CHF.

Technical Strategy
Commodity currencies lagged over the past week, suggesting a growing risk of a short term consolidation. Still, corrective phases are within the context of medium term outperformance. Asia FX trends are accelerating, highlighted by the breakdown in USD/SGD and USD/KRW, with USD/INR expected to follow. The bullish backdrop for MXN and BRL remains intact with USD/BRL positioned for a retest of the medium term range lows. Stay short EUR/TRY, EUR/CZK and NZD/CAD and long USD/JPY. Sell corrective retracements in USD/Asia FX and USD/MXN.

FX Alpha Strategies & Manager Performance
G-10 carry is up nearly 1% on the week while EM carry delivered 2%. Both forward carry and forward momentum overlay are short the USD against AUD and CAD. Hedge fund and currency managers are down slightly on the week.

ENDS

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