FX Update: Fed set to super-size hikes, but BoJ to steal the show?

FX Trading focus: Super-size hikes from Fed now priced, but could BoJ steal the show?

It looks like a 75-basis point Fed rate hike, the largest since 1994, is a done deal according to market pricing after yesterday’s further meltdown in US treasuries, a move that has reinverted the 2-10 portion of the US yield curve and which in turn is beginning to see the market pull forward the anticipation of a US recession into the first half of next year. The Wall Street Journal’s Fed watcher Nick Timiraos wrote the obligatory article on the Fed’s intent to hike 75 basis points (the Fed only does as priced, never wanting to surprise, seems to be the Fed mantra). He noted as we did prominently yesterday that the big jump in the June University of Michigan Sentiment survey’s 5-10 year inflation expectations is a game changer for the Fed on concerns that inflation expectations are becoming “de-anchored”. Timiraos’ article also cites a New York Fed survey released yesterday showing a jump in short term inflation expectations as well as that the “distribution of household’s longer term inflation expectations was more varied than in the past.” These are strong new inputs prompting the Fed to backtrack on its own guidance at the May 4 meeting, when it seemed confident enough to set the speed limit for rate hikes at 50 basis points. Conditions are leading the Fed by the nose, and this recent embarrassment for the Fed could mean that the market is less sensitive to what the Fed says it is going to do tomorrow when it is not in control and lagging so badly.

Trading a Bank of Japan capitulation

Following are ideas only – not trade recommendations.

Interestingly, with this latest leap higher in yields, USDJPY is stuck dead in its tracks and the JPY is firming nearly everywhere else – I suspect as the market is warming up for a possible Bank of Japan capitulation on its yield-curve-control policy even after it announced new operations to stem yield rises as the 10-year JGB tested above the 25 basis point level overnight. Some thoughts on how to trade a JPY jump higher with all of the usual caveats below.

The most straightforward to trade for the Bank of Japan to crater on its commitment to the YCC policy sooner rather than later could be via a long JPY/short risky currency pairing, so something like shorting AUDJPY. That looks a technically interesting trade here already, as the recent attempt above the prior 95.75 area high has now been strongly rejected, even if the follow through lower is not yet complete. With current volatility levels, it is difficult to run anything but a small position in that currency pair.

Otherwise, and for a more leveraged trade that keeps a sustained exposure in the market, options are generally the way to go for more sophisticated traders. One strategy discussed on this morning’s Saxo Market Call podcast is a long USDJPY put spread. The put spread example I took assumed that something may not happen this week, but could happen over the next three months. The example was buying a 3-month 128.00 USDJPY put and selling a 3-month 124.00 USDJPY. Priced earlier this morning at slightly higher price levels (and lower vols – vols are rising rapidly for JPY!), the structure cost about 80 pips, meaning about 320 pips of maximum profit should USDJPY trade 124.00 or below by the expiry, a solid 4 x 1 reward/risk ratio that does, of course, require a massive spot move to get it there.

As mentioned on the podcast, one can tinker with the price levels and time frames to achieve higher reward vs. risk (which likely means USDJPY has to move even more, etc.). The disadvantage of a spread versus a basic long option trade is two-fold: first, the profit is maxed out and can go no higher once the strike price of the short leg of the spread is hit. Second, hedging the position once it starts to move into profit is tricky for non-experts and psychologically annoying. Yes there is an overall delta for the spread structure, but it is far more straightforward to hedge a simple long option position, especially once in the money. The advantage of a long put spread versus a simple long put is that the break even price is far higher for a put spread and the position doesn’t have to move as much to achieve a decent multiple of reward versus risk. Using only the long 128.00 USDJPY put mentioned up above, the 4 x 1 reward to risk ratio if bought at 150 pips where it was trading earlier this morning, would not be achieved until 120.50.

Chart: USDJPY
Chart technicals are a bit pointless when the direction in the near term in USDJPY will likely come down to whether the Bank of Japan shows any signs of capitulating on its yield-curve-control policy due to the pressure cooker from global yields or insists on hanging in there for now. Certainly, the sharp rises in US Treasury yield all along the curve this week is doubling down on the pressure on Governor Kuroda and company to make a move. In recent days, we have seen a period of “doji” candlesticks suggesting the market is having second thoughts on bidding up USDJPY further – particularly interesting given the sharp rise in yields adding pressure as noted above. Implied options volatilities are rising rapidly, meanwhile, and risk reversal show that puts are now being bit up more than calls, providing headwinds for further upside. This is a very dynamic situation and the JPY could be in a very different very soon. Stay tuned and stay careful.