It's Becoming Less Quiet; Time To Sell EUR/JPY

FX volatility may be low but increased activity in equity and bond markets is beginning to spread to currencies, notes Morgan Stanley.

The epicenter of concern, according to MS, is Europe, where equities and peripheral bonds have come off since the ECB introduced easing measures in early June.

"European equities have underperformed other global benchmarks in recent weeks, with bank stocks in particular down 9%. Meanwhile, peripheral bonds have weakened; the Spain-Germany 10y spread has widened by 40 bps from the June lows. Some of the weakness can be attributed to delay of a coupon payment by the parent company of Portuguese bank...Indeed, given crowded positioning and now tight spreads in the European peripheral bond space, further liquidation may be in store as contagion premium gets priced in," MS clarifies.

"Given how much foreigners have invested in Europe over the past two years, we think higher vol is likely to reduce flows into Europe and perhaps lead to outflows," MS adds.

"In an environment of asset market volatility, our favorite way to express a short EUR position is against JPY...Meanwhile, we hold our long-standing view of a tactical correction higher in JPY, as a pick-up in vol and BoJ on the sidelines should lead to JPY strength," MS argues.

In Line with this view, MS added a short EUR/JPY position to its medium-term portfolio at 137.70, with a stop at 139.30, and a target at 132.50.

The key risk to this trade, according to MS, is if recent wobbles in risk are only short-lived.

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