Trump tweet re-introduces trade tensions in FX markets, which could last 1-2M
A deal will eventually arrive but, interim, brace for volatility in JPY crosses
We suggest to buy a 3M (NYSE:MMM) USD/JPY straddle to prepare for a move away from 110
Trade woes are back: just as a US-China trade deal was due, uncertainty was reintroduced with Trump's tariff threats over the weekend, see US-China Trade - New uncertainty as Trump threatens of new tariffs , 6 May 2019. It remains to be seen whether this is just negotiation tactics, or a genuine escalation from the US side. We keep faith that a deal will arrive eventually, but, near term, the risk of renewed escalation has clearly risen. Ahead of the Friday 'deadline' for a tariff hike, FX markets will be highly sensitive to trade headlines. Shaky risk sentiment is likely to keep notably the JPY supported and China-dependent open economies are set to (remain) under pressure. USD/JPY slid below 110.50. What next?
On the one hand, there is a decent chance that clarification could arrive already by the end of this week, i.e. Trump's tactics work and a deal is finalised. This would kill volatility again but fuel a jump back up in USD/JPY. On the other hand, in case of further escalation, i.e. the US is set to play hardball for longer; the experience from 2018 is that risk-off/on cycles driven by trade-war developments tend to last 1-2M (Chart 1). This would add to still-low (in a historical context) volatility and weigh further on USD/JPY.
Tactically, buy a 3M USD/JPY straddle
While highly uncertain where the US and China talks will go this week, we are most certainly in for a move in USD/JPY away from 110. Further, volatility remains in 'cheap' territory even after the latest uptick (Table 1) and will likely rise in case of escalation. As we see both the case for a bigger spot move and an asymmetric case for volatility from here, we recommend buying a 3M ATMF USD/JPY straddle centred around 109.99 (spot ref 110.80) in the Danske FX Trading Portfolio. This costs an indicative 275 pips, i.e. break-even levels at maturity are 107.24 and 112.74. If trade tensions escalate, the trade is set to benefit both from the spot and volatility side as the two tend to move inversely (Chart 2). Key risks are that USD/JPY settles around 110 and/or volatility drifts lower again.
A deal will come - USD/JPY remains a strategic buy on dips
Near-term escalation risks aside, we still look for an extensive US-China trade agreement to arrive during Q2. For FX markets, this means that the palmy days for the safe havens could be over shortly - but it is a close call whether it be this week or later this quarter. When a trade deal lands, JPY weakness is likely on the back of (i) risk sentiment improving and (ii) Japan likely being next on Trump's tariff list, see also Global Research - What a US-China trade deal will bring to the markets , 8 April 2019, for an overview of what to expect from and market implications of an eventual trade deal. We remain long AUD, NZD, CAD vs JPY (spot) in the Danske FX Trading Portfolio in anticipation of a wide-ranging deal (see Table 2) and still see potential in this, even if it would suffer from prolonged trade uncertainty.
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