The runup into Fed

Run up

We are one week away from the FOMC meeting and that means it’s time to think about what the market might do into that critical event. There is a strong belief in the market that Warsh is serious about restoring inflation fighting credibility and while I thought weak data would stymie the hawks, the end of the ceasefire and the upward pressure on energy makes the past data irrelevant. So my best guess is that the market will want to position for a hawkish Fed.

With USD positioning light and the asymmetry towards a hawkish meeting, there is room for the USD to rally over the next seven days. I realize this is a flip in my view (I have been mostly USD bearish for the past few weeks) but just about every reason I was bearish USD (weak data, large USD longs, etc.) has expired. So, it’s time for fresh eyes and as I look at FX with clear eyes and a flat book, I am bullish USD short-term. I never have a problem flipping from one view to the opposite view. Usually when I am trading well, I do that.

When I was in my 30s, and we would go visit hedge funds run by the legends, I always asked the PMs: What do you think makes your founder such a good trader. Inevitably, the answer was something like: “He can be max bearish in the morning meeting and when I look at his position at the end of the day, he’s long.” It was amazing how the answer always came down to some sort of extreme flexibility in thinking. The obvious risk with that sort of flexibility is that you become Flipper McFlipperson and can never stick to a view for more than six minutes. There is a tension between flexibility and flip/flopping. A quick excerpt from Alpha Trader:

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The cure for many forms of bias in trading (and in life) is to be flexible and open-minded. This is captured by the concept of “strong opinions, weakly held”, a framework for thinking developed by technology forecaster and Stanford Scholar Paul Saffo. Here is his description of how to think :

Allow your intuition to guide you to a conclusion, no matter how imperfect — this is the “strong opinion” part. Then – and this is the “weakly held” part – prove yourself wrong. Engage in creative doubt. Look for information that doesn’t fit, or indicators that point in an entirely different direction. Eventually your intuition will kick in, and a new hypothesis will emerge out of the rubble, ready to be ruthlessly torn apart once again. You will be surprised by how quickly the sequence of faulty forecasts will deliver you to a useful result.

This sounds a lot like Bayesian updating. Start with a prior and update it as you get more information.

end of excerpt

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If the USD is likely to rally into FOMC, what currency is best?

I like AUDUSD best because it tends to have a clear and strong beta to USD moves (as opposed to say, USDJPY, which can be wonky due to MOF randomness, etc.) and you have some economic data (Aussie jobs and CPI). And with MAG7 earnings it might be useful that AUDUSD is sometimes sensitive to equity vol. With earnings, AU jobs and CPI, plus FOMC on July 29, and month end slotted in just after, one might think that AUD vol would be pricey. Relative to history, it is not (see first chart). Relative to recent realized vol, it is not super cheap but also not expensive (see second chart). But I expect realized volatility to pick up, and I feel the vol is underpricing this simply because everyone is asleep and things have not been moving.

The trade idea is simple: Buy 2-week 0.6950 AUDUSD puts for around 33bps. I think with a bit of luck, there could be some chances to trade this thing (gamma) and/or use it as a directional bet on a higher USD into and possibly through FOMC. This option is good value with so much excitement coming up and the market currently snoozing. Trade your own view—not investment or trading advice.

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Carry to vol

Our man at Spectra FX Asia, Jonathan Tan, created a nice chart of carry-vol in FX. I plagiarized it, adding a couple of currencies. Here it is.

I am not bullish carry right now, given the prospect of a hawkish FOMC (and/or fears of that scenario) but I do think it’s a cool chart. INR currently highest carry/vol of 95 pairs we look at.

Have an irrational day.

good luck ⇅ be nimble