Over the past few weeks, Citi's Steven Englander has not exactly kept it a secret that in his view, the US Dollar is due for the kind of flash dash that only stocks trading on the NYSE and BATS are capable of doing after reporting horrible news (bizarro market, remember). In an overnight note, Englander presents several scenarios on how to capitalize on what he notes are EURUSD "fat tails that are getting fatter" - specifically i) Long 6-month EUR Put USD Call 1.2500 At-Expiry Digital with KO at 1.3875 and ii) Long 6-month 1.3000/1.2000 EUR Put spread with KO at 1.3875. The 4 reasons why Citi believes conditions are ripe for sharp move in the pair are i) European sovereign debt is far from resolved, ii) Uncertainty emerging from governmental changes in the Middle East, iii) Unwinding commodity price inflation, and iv) Homeland Investment Act-2.
We share a generally positive view of global asset markets with our colleagues in Economics and other Strategy areas, but are finding it increasingly difficult to ignore the very fat tails for USD strength. What makes these fat tails interesting is how realistic they are as potential drivers of a large, abrupt, USD positive move under several plausible scenarios. It is also striking (at least to me) how inexpensive the protection is relative to the risk that a big move occurs.
We have not changed our baseline view that the high liquidity, low rates environment will persist and continue to support growth. This is also broadly the view of our colleagues in Economics and other Strategy areas. We are just finding it increasingly difficult a concentration of acute FX risks that may be moderate individually but are compelling as a group.
Our CSG colleagues on Friday priced out a couple of structures to protect against these abrupt USD-positive moves:
Trade Idea 1 ~ Long 6-month EUR Put USD Call 1.2500 At-Expiry Digital with KO at 1.3875
- Cost: 14% of EUR payout (level on 1.3435 ref)
- Without KO the digital costs 19% of EUR payout
Trade Idea 2 ~ Long 6-month 1.3000/1.2000 EUR Put spread with KO at 1.3875
- Cost: 1.09% of EUR notional (level on 1.3435 ref)
- Without KO the vanilla put spread costs 1.61% of EUR notional
1) European sovereign debt is far from resolved. There are risks related to the Irish election and these seem to be increasingly rather than diminishing; the Weber resignation raises the possibility that divergences among euro area policymakers are even deeper than thought; and beyond rhetoric there still seems lack of consensus on the shape and costing of a comprehensive plan. It looks to us as if rhetoric and goodwill, however sincere, have taken the euro about as far as they are likely to take it.
2) Uncertainty emerging from governmental changes in the Middle East. From a G10 markets perspective, there is concrete upside from liberating market forces in a region which has lagged growth elsewhere, but the benefits will likely emerge only over the long term from having a new region of fast-growing markets. Like many positive structural changes the benefits emerge only over the very long-term. By contrast if the abrupt political transitions end up disrupting oil supplies, the negative effects will be felt instantly. Thus while it is arguable that so far the transitions have gone remarkably smoothly, the distribution of potential gains and losses to G10 markets in the short term is very asymmetric.
An energy shock that stemmed from supply disruption would probably lead to weaker growth, weaker equity markets, lower non-oil commodity prices and less risk appetite. These correlations are different from those observed in recent years because oil price rises that stem from growing demand will have different correlation with other asset markets than hikes than come from supply shocks.
The losers would be currencies belonging to high-beta, non-oil commodity exporters and to economies that have large current account deficits. Position cutting would also be a widespread phenomenon so today's favorite trades would be tomorrow's dogs. While the US is a big energy importer, the USD would probably benefit more from the risk-off environment than it would from the worsened terms of trade. That does not mean at all that the US economy would emerge unscathed but the US's economic would probably not be reflected in the currency in a world where two years or more of trades and positions are being unwound.
3) Unwinding commodity price inflation -- if EM countries tighten too much and cause and undesired global slowdown, the USD will benefit. More benignly we have argued that EM buying USD against other G10 currencies would have knock-on effect on commodity prices, just as USD weakness had the opposite effect. If inflation is the problem a combination of stronger USD against G10 and stronger EM currencies against USD is probably the most efficient and cost-effective way of quickly shocking inflation down in the short-term.
4) HIA-2. The Administration is pushing for comprehensive corporate tax reform, but comprehensive revenue neutral, tax reform will produce little, if any, cyclical stimulus. It will also create big losers and winners among US corporations, so will not be universally endorsed. HIA-2 is there as a fall back if comprehensive reform does not work, or as a sweetener to broad tax reform. Treasury Secretary Geithner last week said -- "“We are not going to look at a repatriation holiday outside the context of comprehensive reform.” -- but that certainly opens a few doors either as an add-on to comprehensive reform or if it fails.
Note that while scenarios all are USD positive not all are risk negative. The first two pose the most risk for a broad risk-off type of move, but EM and USD appreciation that allows pressure on global rates to ease is probably risk positive, as is HIA-2.