FX Traders Beware, Risk Impulse Looming

While risk assets retain their sanguine outlook, debt markets suggest investors are taking a more cautious stance. Indeed having already made year-to-date highs last week, the continued steepening of the US Treasury curve warns a meaningful change in perception is underway. Similarly, short-end rate expectations appear to be shrugging-off the weak March Non-Farm Payrolls with the USD3x6FRA nearly 10bp above its Yellen-inspired 3 April low. Perhaps US rates markets are finally questioning what risk assets still seem to consider an implicit Fed liquidity guarantee? If so, trouble may be ahead.

In FX-terms, such questioning argues that USD-funding concerns are to return impacting both USD and funding dependent high-yield currencies. Indeed, unless you believe recent USD weakness was almost exclusively behind dampened Fed tightening restrictions (ie, the ‘FX tail wagged the Fed policy dog’), an important disconnect may be emerging between FX and rate markets outlooks. Indeed if rate market concerns are proven correct in the coming days, rising USD-funding stress will reveal USD is undervalued and risk currencies overvalued at current levels.

While the gravitational pull of USD-funding stresses are the dominant FX market theme they are by no means the only theme. The next risk aversion impulse need not emanate from FX investor perceptions catching-up to their rates counterparts’, but from a financial contagion shock in Europe or elsewhere. Importantly, however, while the risk-off catalyst could differ, its results should prove similar with USD higher and the risk currencies lower irrespective.

In sum, irrespective is their catalyst, short-date insurance, ie, in terms of both equity and FX volatility, seem like good value here given signals from the rates markets. Higher-yielding FX peripheral vols likely represent particularly good value.

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