By John J Hardy
This week we focus on sterling-related themes, as the pound has been one of the more volatile currencies of late on the falling perceived odds of a Brexit after the June 23 referendum.
For USD traders, next week could prove difficult in terms of trading conditions, as we clearly have a market that has raised its anticipation of a Federal Reserve interest rate hike this summer (more likely July, though the odds of even a July hike are only priced at about 50/50 currently).
The market also, however, knows that the Fed is highly data-dependent, and next week features most of the critical data releases that will point to whether the Fed pulls the lever sooner or later, so the US prints will have the potential to spark significant reactions, starting with Tuesday’s April PCE inflation report.
Longer-term (post-UK referendum) GBPUSD downside via options
The June 23 UK referendum has brought a frenzy of speculation on the fate of sterling should UK voters vote to leave the EU, but the strong shift in favour of the Remain vote in recent polling has sparked a significant sterling rally on position squaring and the general change in sentiment.
There may be some further room for the squeeze in sterling shorts to run – especially in the immediate wake of a Remain result on June 23 – but in an environment featuring a more hawkish Fed and stronger USD, much of the relief of a Remain vote scenario may already be priced in.
Those wanting to look to look through the short-term volatility might consider (now more) reasonably priced option strategies for longer term GBPUSD downside in recognition of the widening US rate advantage and the UK’s structural challenges (world’s largest current account deficit for a developed country at 5-6% of GDP).
GBPUSD bears should note that with the recent recovery in sterling, the surprise of a Leave vote at the referendum would now be now far larger and ironically far less costly to trade than it was in previous weeks when fear levels were far higher.
Trading stance: Cautious traders will look to only trade half a bearish sterling position in the near term here, hopefully from new local highs in the price early next week (the 200-day moving average, for example, comes in around 1.4750 next week), and add a second half at even higher spot levels or on an enthusiastic response to the upside in GBPUSD shortly after the referendum itself (assuming a Stay vote, which would likely see option implied volatilities rapidly falling).
Those looking at the longer-run potential for GBPUSD downside may look at three-to six-month options strategies for GBPUSD returning to 1.41 or lower, with put spreads offering more compelling reward for the risk than vanilla puts if GBPUSD were only to fall modestly, as opposed to a huge drop.
It should be noted, however, that spread trades are more challenging to hedge.Trade examples include: a three-month 1.42/1.38 put spread, with spot trading at 1.4665 on Friday, costs about 103 pips for a maximum payout at 297 pips if GBPUSD is trading at 1.38 or lower on expiry 26 August (slightly less than 3 x 1 reward to risk). That’s less than half the price of a plain vanilla 1.42 put.
A 1.45/1.41 put for the same expiry/same spot reference costs around 133 pips for a maximum payout of 267 pips, only about 2 x 1 reward to risk, but maximum payout achieved at a price at the 1.41 option strike.
Long GBP tactically versus CAD, other currencies
Despite our expressed interest in looking for for sterling downside versus the US dollar, there may be a good deal more to wring out of the pound squeeze to the upside in the near term as short positioning remains heavy and there is further room for unwinding of the short positioning amid hopes that a Remain vote will mean significant relief on the pound and the UK economy in the near term.
Looking for currencies to short against sterling, we single out CAD on its vulnerability to oil price declines.
Trading stance: Traders will look for gains toward 1.95-plus as long as the daily closes remain above 1.90.
Short EURUSD on rallies
Volatility in EURUSD has been declining to a remarkable degree in recent weeks, in part because the attempted break higher recently never amounted to anything. Another possibility is that while the Federal Reserve has significantly boosted rate hike expectations, it's seen by the market as likely to pursue a very cautious pace of policy unwinding, and the relatively higher inflation in the US has held the USD back on a focus on low real rates.
Nonetheless, rate spreads for the pair continue to point south and EURUSD is likely to continue lower within the long standing 1.06-1.15 range in the weeks ahead, even if the pace of further declines from here may slow.
Trading stance: EURUSD bears will fade rallies ahead of the 1.1200/50 zone, looking for follow up selling to the 1.1000. Should US data surprise to the downside next week, any rallies may prove relatively short-lived and fade ahead of 1.1350/75, where bears may look for fresh attempts to fade the upside.
NZDUSD bears have been frustrated by the pair's inability to fully break down into the old range toward 0.6600, but assuming US data don’t surprise notably to the downside, next week could finally see this happen as the diverging central bank policy trajectories of the Fed relative to the Reserve Bank of New Zealand argue for a revisit of the lows for the cycle eventually, and at least a look at 0.6600 in the near term.
Trading stance: NZDUSD bears will look to stay short NZDUSD as long as the price action remains below 0.6800 for a test toward at least 0.6600 in the week or two ahead.
The New Zealand dollar remains at the relative heights, but policy divergence
will likely send it over the edge (versus USD) sooner or later. Photo: iStock
— Edited by Michael McKenna