G10 FX Weekly – Boiling below the surface

by: Georgette Boele , Roy Teo

In this publication: GBP spot market is relatively calm… while the FX options market is far from that. Fate of US dollar hinges on US employment report. JPY gains due to expectations of lower BoJ easing. RBA and RBNZ to keep OCR unchanged next week.

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Divergence between sterling option and spot market

This week, the latest UK EU referendum poll showed that the ‘Leave’ camp had taken over the lead over the ‘Remain’ camp. This resulted in a weakening of sterling. A remarkable divergence has developed on between the FX options and the FX spot market. The FX spot market looks relatively calm while the FX options market is more in a state of panic.

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The demand to hedge against falls in sterling has risen sharply resulting in levels not seen since 2004 (the preference for puts over calls has risen to extreme levels) and the referendum is still more than three weeks away. Often such activity impacts the spot market as well. However, up to now there are little signs of this. The depth in the spot market could currently be large enough to absorb these option market related flows. Another reason could be that at this point in time market makers are not unwinding these positions. If so, they may do this at a later stage or after result of the referendum is known. If the outcome were to be a Brexit (not our base case) then a sharp sell-off in sterling in the spot market will likely be the result.

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High focus on US employment report

Since the end of last week, the US dollar recovery has come to a halt. Weaker-than-expected Chicago PMI and Consumer confidence outweighed the better-than-expected data. There is a realisation in financial markets that if US employment report tomorrow comes in weaker-than-expected their expectations towards the Fed may be too optimistic. As a result, some of the rate hike expectations for this year (especially for the near-term) could be scaled back and the US dollar could move lower. On the other hand, a stronger report including higher-than-expected hourly-earnings could trigger a sharp rise in rate hike expectations for June and July and a higher US dollar. Currently, the odds for a rate hike in June are 22% and for July 53%. So the focus on the US employment report will even be higher than usual.

Yen gains due to lower expectations of BoJ easing

The Japanese yen (JPY) strengthened from above 111 to 109 against the US dollar due to market expectations that the Bank of Japan (BoJ) will not increase monetary stimulus anytime soon. This was after Japan Prime Minister Abe said that the planned sales tax hike in April 2017 will be delayed by two and a half years to late 2019. Mr. Abe added that the government will proceed with structural reforms and fiscal stimulus. However, more monetary policy easing is still our base case given the low inflation outlook. On top of this, we had already expected that Japanese authorities would delay the VAT hike, which is already included in our base scenario.

RBA and RBNZ to keep OCR unchanged next week

We expect both the Reserve Bank of Australia (RBA) and Reserve Bank of New Zealand (RBNZ) to keep the Official Cash Rate (OCR) unchanged next week. In Australia, the strong Q1 GDP print has reduced market expectations that the RBA will lower the OCR in the coming months. We maintain our view that the RBA is likely to resume their monetary easing bias in August this year due to weak inflationary pressures. The strong Q1 GDP print is mainly attributed to large contribution from net exports. Since 2013, net exports have been strong in the first quarter before fading in the following quarter.

Separately, the RBNZ is also likely to keep their powder dry next week given strong gains in the terms of trade and resilient house prices. As financial markets are pricing in about 25% probability of a 25bp rate cut next week, the New Zealand dollar (NZD) may gain some support. However, we expect the RBNZ to resume their easing bias later this year in August.

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